FINANCIAL STABILITY OVERSIGHT COUNCIL OVERSIGHT STABILITY FINANCIAL
2020
ANNUAL REPORT 2020 REPORT ANNUAL
FINANCIAL STABILITY OVERSIGHT COUNCIL
1500 PENNSYLVANIA AVENUE, NW | WASHINGTON, D.C. 20220
FINANCIAL STABILITY OVERSIGHT COUNCIL
Financial Stability Oversight Council
The Financial Stability Oversight Council (Council) was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and is charged with three primary purposes:
1. To identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.
2. To promote market discipline by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the U.S. government will shield them from losses in the event of failure.
3. To respond to emerging threats to the stability of the U.S. financial system.
Pursuant to the Dodd-Frank Act, the Council consists of ten voting members and five nonvoting members and brings together the expertise of federal financial regulators, state regulators, and an insurance expert appointed by the President.
The voting members are:
• the Secretary of the Treasury, who serves as the Chairperson of the Council; • the Chair of the Board of Governors of the Federal Reserve System; • the Comptroller of the Currency; • the Director of the Consumer Financial Protection Bureau; • the Chairman of the Securities and Exchange Commission; • the Chairman of the Federal Deposit Insurance Corporation; • the Chairman of the Commodity Futures Trading Commission; • the Director of the Federal Housing Finance Agency; • the Chairman of the National Credit Union Administration; and • an independent member having insurance expertise who is appointed by the President and confirmed by the Senate for a six-year term.
The nonvoting members, who serve in an advisory capacity, are:
• the Director of the Office of Financial Research; • the Director of the Federal Insurance Office; • a state insurance commissioner designated by the state insurance commissioners; • a state banking supervisor designated by the state banking supervisors; and • a state securities commissioner (or officer performing like functions) designated by the state securities commissioners.
The state insurance commissioner, state banking supervisor, and state securities commissioner serve two-year terms.
Financial Stability Oversight Council i Statutory Requirements for the Annual Report Section 112(a)(2)(N) of the Dodd-Frank Act requires that the annual report address the following: i. the activities of the Council; ii. significant financial market and regulatory developments, including insurance and accounting regulations and standards, along with an assessment of those developments on the stability of the financial system; iii. potential emerging threats to the financial stability of the United States; iv. all determinations made under Section 113 or Title VIII, and the basis for such determinations; v. all recommendations made under Section 119 and the result of such recommendations; and vi. recommendations— I. to enhance the integrity, efficiency, competitiveness, and stability of United States financial markets; II. to promote market discipline; and III. to maintain investor confidence.
Approval of the Annual Report This annual report was unanimously approved by the voting members of the Council on December 3, 2020.
Abbreviations for Council Member Agencies and Member Agency Offices
• Department of the Treasury (Treasury) • Board of Governors of the Federal Reserve System (Federal Reserve) • Office of the Comptroller of the Currency (OCC) • Consumer Financial Protection Bureau (CFPB) • Securities and Exchange Commission (SEC) • Federal Deposit Insurance Corporation (FDIC) • Commodity Futures Trading Commission (CFTC) • Federal Housing Finance Agency (FHFA) • National Credit Union Administration (NCUA) • Office of Financial Research (OFR) • Federal Insurance Office (FIO)
ii 2020 FSOC // Annual Report Contents
1 Member Statement...... 1
2 Executive Summary...... 3
3 Financial Developments...... 11
3.1. Household Finance...... 11 3.2. Nonfinancial Business Finance...... 15 Box A:.Nonfinancial Corporate Credit: Financial Market Fragilities and the COVID-19 Pandemic...... 19 3.3. Government Finance...... 24 Box B:.U.S. Treasury Market Liquidity at the Onset of the COVID-19 Pandemic27. Box C: Finances of State and Local Authorities and the COVID-19 Pandemic .33 3.4. Financial Markets ...... 35 Box D:.Recent Stress in Short-Term Wholesale Funding Markets...... 43 Box E: Potential Risks in Commercial Real Estate...... 74 3.5. Financial Institutions...... 77 3.6. Financial Market Structure, Operational Challenges, and Financial Innovation...... 118 3.7. Global Economic and Financial Developments...... 128
4 Council Activities and Regulatory Developments.....141
4.1. Select Policy Responses to Support the Economy...... 141 4.2. Council Activities...... 143 4.3. Safety and Soundness...... 145 4.4. Financial Infrastructure, Markets, and Oversight...... 154 4.5. Mortgages and Consumer Protection ...... 160 4.6. Data Scope, Quality, and Accessibility...... 163
Contents iii 5 Potential Emerging Threats, Vulnerabilities and Council Recommendations...... 167
5.1. Nonfinancial Business: Corporate Credit ...... 167 5.2. Financial Markets...... 168 Box F:.Council Statement on Activities-Based Review of Secondary Mortgage Market Activities...... 171 5.3. Financial Institutions...... 173 5.4. Financial Market Structure, Operational Challenges, and Financial Innovation ...... 175 5.5. Global Economic and Financial Developments...... 184 Box G:.“Low-For-Long” Interest Rates and Implications for Financial Stability ...... 186 6 Abbreviations...... 189
7 Glossary...... 193
8 List of Charts...... 203
iv 2020 FSOC // Annual Report 1 Member Statement
The Honorable Nancy Pelosi The Honorable Michael R. Pence Speaker of the House President of the Senate United States House of Representatives United States Senate The Honorable Kevin McCarthy The Honorable Mitch McConnell Republican Leader Majority Leader United States House of Representatives United States Senate The Honorable Charles E. Schumer Democratic Leader United States Senate
In accordance with Section 112(b)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, for the reasons outlined in the annual report, I believe that additional actions, as described below, should be taken to ensure financial stability and to mitigate systemic risk that would negatively affect the economy: the issues and recommendations set forth in the Council’s annual report should be fully addressed; the Council should continue to build its systems and processes for monitoring and responding to emerging threats to the stability of the U.S. financial system, including those described in the Council’s annual report; the Council and its member agencies should continue to implement the laws they administer, including those established by, and amended by, the Dodd-Frank Act, through efficient and effective measures; and the Council and its member agencies should exercise their respective authorities for oversight of financial firms and markets so that the private sector employs sound financial risk management practices to mitigate potential risks to the financial stability of the United States.
Steven T. Mnuchin Jerome H. Powell Secretary of the Treasury Chairman Chairperson, Financial Stability Oversight Council Board of Governors of the Federal Reserve System
Brian P. Brooks Kathleen Kraninger Acting Comptroller of the Currency Director Office of the Comptroller of the Currency Bureau of Consumer Financial Protection
Jay Clayton Jelena McWilliams Chairman Chairman Securities and Exchange Commission Federal Deposit Insurance Corporation
Heath P. Tarbert Mark A. Calabria Chairman Director Commodity Futures Trading Commission Federal Housing Finance Agency
Rodney E. Hood Thomas E. Workman Chairman Independent Member Having Insurance Expertise National Credit Union Administration Financial Stability Oversight Council
Member Statement 1
2 Executive Summary
The U.S. economy was in the midst of the longest and reductions in the availability of short-term post-war economic expansion, with historically low funding. Substantially increased liquidity and capital levels of unemployment, prior to the onset of the requirements imposed after the 2008 financial COVID-19 pandemic earlier this year. The global crisis helped banks meet the large, unanticipated pandemic not only brought about a public health drawdowns. Large deposit inflows from investors crisis but also caused a contraction of economic fleeing to the safety of deposit insurance and activity at an unprecedented pace. Initially, the borrowings at the Federal Reserve’s discount window pandemic reduced consumer spending, slowed also helped in meeting this surge in liquidity demand. manufacturing production, and led to widespread business closures. The unemployment rate surged Meanwhile, policymakers acted to minimize the from 3.5 percent in February to a record high of health and economic effects of the pandemic. nearly 15 percent in April. Since then, extraordinary On March 27, the Coronavirus Aid, Relief, and measures undertaken by policymakers have Economic Security (CARES) Act was signed into succeeded in arresting the decline in economic law. The CARES Act authorized approximately conditions, initiating a recovery and lowering the $2.6 trillion in funding to address COVID-19 and unemployment rate to 7.9 percent as of September. to support the economy, households, businesses, However, a protracted virus outbreak poses and other entities. In addition, the Federal Reserve downside risks that can slow the recovery and even and Treasury undertook a series of extraordinary prolong the economic downturn. measures beginning in March to contain the financial fallout from the pandemic. The Federal Financial Stress from the COVID-19 Pandemic Reserve also lowered the target federal funds and the Policy Response rate to near zero and substantially increased The COVID-19 outbreak led to substantial financial purchases of Treasuries and agency MBS to ease stress in the first quarter of 2020. While economic trading pressures. In a bid to stabilize short-term activity was disrupted in March, investors fled riskier funding markets (STFMs), the Federal Reserve assets for the safety and liquidity of cash and short- launched a series of facilities to provide liquidity to term government securities. A broad-based selloff in foreign central banks, primary dealers, depository equities and commodities resulted in sharp declines institutions, and money market funds. In light of in both spot and futures prices. The sectors most these exigent circumstances, the Federal Reserve affected by the pandemic, such as airlines, energy, and Treasury also enacted a series of unprecedented transportation, hotels, and restaurants, recorded measures to support corporate bonds, bank loans, the sharpest declines. The flight to safety and longer-term municipal debt, and asset-backed liquidity also created disruptions in short-term and securities. These credit and lending facilities were global dollar funding markets. Meanwhile, trading developed with the goal of relieving strains in conditions for Treasuries and agency mortgage- longer-term debt markets through the pandemic. backed securities (MBS), generally considered safe and liquid assets, were also strained. Moreover, These policy actions have substantially improved credit conditions tightened in the commercial paper market conditions and investor sentiment in (CP), corporate bond, and municipal debt markets. financial markets. Federal Reserve purchases of Treasuries and agency MBS reduced bid-ask spreads With the stress in funding markets in March, and relieved the stress in trading conditions for precautionary draws by nonfinancial businesses these securities. The announcement of liquidity on existing lines of credit with banks increased facilities not only succeeded in lowering spreads sharply, as firms tried to cover shortfalls in revenues on CP and short-term municipal securities but also
Executive Summary 3 reversed the heavy redemptions from prime and Though policy actions to minimize the effects of the tax-exempt money funds. The creation of new credit pandemic have been effective at improving market facilities lowered spreads on corporate bonds and conditions, risks to U.S. financial stability remain revived new issuance in both the investment grade elevated compared to last year. In addition, the and high-yield bond segments. Overall, these policy global outlook for economic recovery is uncertain, measures have restored the orderly functioning of depending on the severity and the duration of the financial markets and improved investor sentiment, ongoing pandemic. as reflected in the rebound in corporate financing and equity prices. Corporate Credit The corporate debt-to-gross domestic product The Council provided an important venue for (GDP) ratio was at historic highs when the facilitating coordination and analysis of risks across pandemic hit the United States. As economic activity member agencies at the onset of the pandemic and contracted in March, there were serious concerns throughout the year. Council members regularly about the sustainability of corporate debt. Since identified key risks and shared information then, the corporate debt-to-GDP ratio has reached regarding their policy responses. The Council also new record highs, and, despite the turmoil in credit increased the frequency of staff-level meetings markets, the policy-aided rebound in business to allow important analyses of major market financing has been strong. developments to be shared in a timely manner with all Council member agencies. In addition, the The potential risk to financial stability from Council’s previous identification of vulnerabilities nonfinancial business borrowing depends on the and analysis that it had performed leading up to the ability of businesses to service their obligations, financial stress helped ensure that policymakers’ the ability of the financial sector to absorb losses responses were more coordinated, well informed, from defaults and downgrades, and the continued and effective. willingness of market participants to provide intermediation during times of stress. Implications for Financial Stability A key goal of the Council and its member agencies Elevated valuations in U.S. equities and corporate is to monitor vulnerabilities to U.S. financial bonds make these markets vulnerable to a major stability so that abrupt and unpredictable changes repricing of risk, increasing volatility, and weakening in economic or financial conditions – “shocks” – do balance sheets of financial and nonfinancial not disrupt the ability of the financial system to meet businesses. Sharp reductions in the valuations of the demand for financial services. Vulnerabilities different assets could negatively impact liquidity, include structural weaknesses in the financial system increase borrowing costs, and heighten rollover risk. and its regulatory framework. Vulnerabilities in the financial system can amplify the impact of an initial With cash flows impaired due to the COVID-19 shock, potentially leading to substantial disruptions pandemic, many businesses may be challenged to in the provision of financial services, such as the service their debt. Since March, nearly $2 trillion in clearing of payments, the provision of liquidity, and nonfinancial corporate debt has been downgraded, the availability of credit. and default rates on leveraged loans and corporate bonds have increased considerably. The growing The COVID-19 pandemic was an extraordinary number of bankruptcy filings could stress resources shock to the global financial system. As discussed at courts and make it harder for firms to obtain above, it led to a significant disruption in the critical debtor-in-possession financing. It could also provision of liquidity and the availability of credit, prevent many firms from restructuring their debt reflecting increasing pessimism and uncertainty in a timely fashion, potentially forcing them into about the economic outlook as major portions of the liquidation. economy began to shut down.
4 2020 FSOC // Annual Report The Council recommends that agencies continue more margin calls. The complexity of interactions to monitor levels of nonfinancial business leverage, involving leveraged participants raises concerns as to trends in asset valuations, and potential implications their role in amplifying funding stresses. for the entities they regulate, in order to assess and reinforce the ability of the financial sector to The Council recommends that regulators review manage severe, simultaneous losses. Regulators and these structural vulnerabilities, including the market participants should also continue to assess vulnerability of large-scale redemptions in prime ways in which leveraged nonfinancial corporate and tax-exempt MMFs, and the role leveraged borrowers and elevated asset prices may amplify nonbank entities may have played in the repo stresses in the broader market in the event of a rapid market. The Council also recommends that, if repricing of risk or a slowdown in economic activity. warranted, regulators take appropriate measures to mitigate these vulnerabilities. Short-Term Wholesale Funding Markets The short-term funding market provides essential Residential Real Estate Market: Nonbank funding to businesses, local governments, and other Mortgage Origination and Servicing financial intermediaries and can have implications for As the shock from the pandemic hit U.S. financial stability and the implementation of monetary households, federal and state governments enacted a policy. Recent events, including the financial fallout series of public assistance policies to aid households, from the pandemic, have confirmed that potentially such as suspending foreclosures, discouraging significant structural vulnerabilities remain in STFMs. evictions, and offering flexibilities in home purchase and mortgage acquisition processes. The disruption Money market funds (MMFs) offer shareholders in mortgage payments has focused attention on redemptions on a daily basis while holding many nonbank mortgage origination and servicing. short-term assets that are less liquid, especially in times of stress. Stresses on prime and tax-exempt While the business models of nonbank mortgage money funds in March revealed continued structural companies vary, many are subject to certain vulnerabilities, which led to increased redemptions fragilities, such as a heavy reliance on short-term and, in turn, likely contributed to the stress in funding, obligations to continue to make servicing STFMs. Among institutional and retail prime MMFs, advances for certain delinquent borrowers, and outflows as a percentage of fund assets exceeded limited resources to absorb adverse economic that of the September 2008 crisis. Outflows abated shocks. The surge in refinancing due to low rates after the Federal Reserve announced support for the has provided servicers with an additional source CP market and MMFs. of liquidity to help sustain operations. An increase in forbearance and default rates, however, has the Liquidity demand from leveraged participants, potential to impose significant strains on nonbank such as hedge funds using Treasury collateral and servicers. mortgage real estate investment trusts (mREITs) using agency MBS collateral, may have also played a The Council encourages relevant state and significant role in the recent market volatility. Some federal regulators to take additional steps to of these leveraged participants are vulnerable to coordinate, collect and share data and information, funding risks because of their reliance on funding identify and address potential risks, and strengthen in repurchase agreement (repo) markets. When the oversight of nonbank companies involved in the such leveraged participants face margin calls (either origination and servicing of residential mortgages. because of an external shock to the repo market or investor concerns about their profitability), it Commercial Real Estate Market creates incentives for them to deleverage. Since the The impact of COVID-19 has adversely affected assets on their balance sheets are the same assets several components of the commercial real estate used as collateral in their repo funding, the need to (CRE) market, including the hotel, retail, and deleverage can increase selling pressures and lead to office segments. A prolonged downturn leaves
Executive Summary 5 the CRE sector vulnerable to mortgage defaults supervisory review and feedback on the resolution and declines in valuations, with spillovers to the plans of large banking organizations, on-site broader economy. While there is variation in examinations and off-site monitoring, and economic different institutions’ exposures to pandemic-driven analysis. CRE stress, a sizeable proportion of CRE loans is currently held on bank balance sheets, with small The Council recommends that financial regulators and mid-sized banks more likely to be concentrated ensure that the largest financial institutions in CRE. Distress in CRE properties makes these maintain sufficient capital and liquidity to ensure creditor banks vulnerable to losses and write-downs, their resiliency against economic and financial with the potential to tighten credit and dampen the shocks. In particular, the Council recommends that economic recovery. regulators continue to monitor the capital adequacy for these banks and, when appropriate, phase out The Council recommends that regulators continue the temporary capital relief currently provided. to monitor volatility in CRE asset valuations, the level of CRE concentration at banks and other The Council also recommends that regulators entities that hold CRE loans, and the performance continue to monitor and assess the impact of rules of CRE loans. The Council recommends that on financial institutions and financial markets— regulators continue to encourage banks and other including, for example, on market liquidity entities, such as REITs and insurance companies, and capital—and ensure that large BHCs are to bolster, as needed, their loss-absorption capacity appropriately monitored based on their size, risk, by strengthening their capital and liquidity buffers, concentration of activities, and offerings of new commensurate with the levels of CRE concentration products and services. on their balance sheets. Investment Funds Large Bank Holding Companies Investment funds play a critical intermediary The banking system has been able to withstand the role in the U.S. economy, promoting economic financial fallout of the pandemic in part because growth through efficient capital formation. While of the stronger capital and liquidity positions recognizing these benefits, the Council has also built up over the last decade. Large bank holding identified potential vulnerabilities relating to companies (BHCs) have also benefitted from the redemption risk in certain open-end funds. For extraordinary policy measures and other supervisory example, though both equity and fixed-income and regulatory relief provided under these exigent oriented open-end funds offer daily redemptions circumstances. to investors, some fixed-income markets are less liquid than equity markets, and thus funds holding A severe and prolonged economic deterioration, mostly fixed-income instruments may face greater however, can affect the resilience of the banking vulnerability to run risk than funds holding mostly system. Financial distress at a large, complex, equities. The Council has focused in particular on interconnected BHC has the potential to affect the question of whether the structure of open-end global financial markets and amplify the negative funds results in greater selling pressure than if impact on economic growth by further tightening investors held the fixed income instruments directly. credit conditions. During the mid-March financial turmoil, credit The Council is closely monitoring the resilience spreads increased to levels not seen since the 2008 of large BHCs and remains vigilant about their financial crisis, and corporate bond issuance willingness and ability to provide credit should came to a near halt. Meanwhile, bond funds economic conditions deteriorate further. Member experienced historically high levels of outflows agencies use a wide range of tools to identify that some research has suggested contributed to and address risks to these institutions, including stress in corporate and municipal bond markets. supervisory and company-run stress tests, Interventions by the Federal Reserve and Treasury
6 2020 FSOC // Annual Report ultimately restored orderly functioning in the Pressures on Dealer Intermediation: The financial primary and secondary markets. Nonetheless, fallout from the pandemic was disruptive in the these events demonstrate the need for additional markets for critical securities such as Treasury analysis to assess broader market structure dynamics securities, MBS, and corporate bonds. Traditionally, that may have contributed to the stress, including market-making and arbitrage mechanisms involving whether investors redeeming shares from bond securities dealers have helped in the orderly funds may have affected the extent of selling functioning of the secondary markets for Treasury pressure in the bond market differently than if those securities and MBS. However, with the increase in investors had held and sold bonds directly. issuance volumes (especially for Treasury securities) In addition to the potential vulnerability associated and the implementation of Basel III regulations on with redemption risk in mutual funds, the capital and leverage, major bank-affiliated broker- Council has also previously highlighted the use of dealers have reduced the amounts of their balance leverage by investment funds. Leverage introduces sheets allocated to trading and repo transactions. counterparty risk, and in a period of stress, if Together, these developments may have contributed leveraged investment funds are forced to sell assets to episodes of illiquidity in Treasury security and on a significant scale, it could exacerbate asset price MBS markets in March 2020. movements. Nontraditional Market Participants: Non- The Council recommends that the SEC and other traditional market participants, including principal relevant agencies consider whether additional steps trading firms, play an increasingly important role should be taken to address these vulnerabilities. in securities and other markets. These firms may The Council also supports initiatives by the SEC and improve liquidity and investor outcomes under other agencies to address risks in investment funds normal circumstances, but they may also introduce through various measures, including data collection risk. The trading strategies that non-traditional efforts and additional reporting requirements. market participants employ and the incentives and constraints that they operate under may not be as Financial Market Structure well understood, leading to uncertainty concerning The extreme volatility in financial markets early in how these firms might behave during periods of the pandemic further emphasized the importance market stress. of ensuring that appropriate market structures are in place so that financial markets can function The Council recommends that member agencies effectively during stress events. conduct an interagency operational review of market structure issues that may contribute to Interlinkages among Dollar Funding Markets: market volatility in key markets, including short- In the decade since the last financial crisis, term funding, Treasuries, MBS, and corporate bond new regulations on bank capital and liquidity, markets, and study the interlinkages between them. structural reforms in MMFs, and a new operating The Council recommends that financial regulators environment for bank-affiliated broker-dealers have continue to monitor and evaluate ongoing changes fundamentally altered how market participants that might have adverse effects on markets, interact and the various interlinkages among including on market integrity and liquidity. the federal funds market, the repo market, and the Eurodollar market. There are benefits from Central Counterparties interdependencies among markets, including Although central counterparties (CCPs) provide enhanced price discovery and more options for significant benefits to market functioning and hedging risks. At the same time, interdependencies financial stability, the inability of a CCP to meet create transmission risks from volatile or inaccurate its obligations arising from one or more clearing pricing that have the potential to amplify market member defaults could potentially introduce strains shocks across different markets. on the surviving members of the CCP and, more broadly, the financial system. At the same time,
Executive Summary 7 CCPs’ internal risk management frameworks are pandemic, the assumption that firms cannot rely on designed to reduce these risks by imposing liquidity LIBOR (formerly known as the London Interbank and resource requirements on clearing members Offered Rate) being published after the end of 2021 that can increase with market volatility. In addition, had not changed. The failure of market participants both the CFTC and SEC maintain active risk to adequately analyze their exposure to LIBOR and surveillance programs of CCPs’ and intermediaries’ transition ahead of LIBOR’s anticipated cessation risk management and receive daily or weekly reports or degradation could expose market participants to on positions, risk measures, margins, collateral, and significant legal, operational, and economic risks default resources. Supervisory stress tests involving that could adversely impact U.S. financial markets. multiple CCPs can also be an important tool in the assessment of risks. The Alternative Reference Rates Committee (ARRC), a group of private-market participants In response to the market volatility in March 2020, convened by the Federal Reserve and the Federal aggregate margin levels increased significantly, Reserve Bank of New York (FRBNY) in 2014, but the markets served by the CCPs continued to has released the Recommended Best Practices for function in an orderly fashion. While the cleared completing the transition from LIBOR. Market derivatives markets functioned as designed, there is participants that have determined that the Secured continued concern about the impact of contingent Overnight Financing Rate (SOFR) is an appropriate liquidity demands on clearing members and their rate for their LIBOR transition should not wait for clients related to margin requirements. the possible introduction of the forward-looking SOFR term rates to execute the transition. The Council recommends that the CFTC, Federal Reserve, and SEC continue to coordinate in the The Council commends the efforts of the ARRC supervision of all CCPs designated by the Council and recommends that the ARRC continue its work as systemically important financial market utilities to facilitate an orderly transition to alternative (FMUs). Relevant agencies should continue reference rates. The Council recommends that to evaluate whether existing risk management market participants formulate and execute expectations for CCPs are sufficiently robust to transition plans so that they are fully prepared for mitigate potential threats to financial stability. the anticipated discontinuation or degradation The Council also encourages agencies to continue of LIBOR. Federal and state regulators should to monitor and assess interconnections among determine whether further guidance or regulatory CCPs, their clearing members, and other financial relief is required to encourage market participants institutions. While margin requirements have to address legacy LIBOR portfolios. Council increased significantly in the aftermath of the member agencies should also use their supervisory financial fallout from the COVID-19 pandemic, authority to understand the status of regulated agencies should continue to analyze and monitor the entities’ transition from LIBOR, including their impact of regulatory risk management frameworks legacy LIBOR exposure and plans to address that in cleared, uncleared, and related securities exposure. markets and their impact on systemically important intermediaries and their clients. Finally, the Council Cybersecurity encourages regulators to continue to advance Financial institutions continue to invest in and recovery and resolution planning for systemically expand their reliance on information technology important FMUs and to coordinate in designing and cloud-based computing to reduce costs and to and executing supervisory stress tests of multiple increase efficiency and resiliency. The COVID-19 systemically important CCPs. pandemic may accelerate this trend as financial institutions have implemented business continuity Alternative Reference Rates plans through increased use of teleworking systems In March 2020, the UK Financial Conduct Authority and dual-work locations. At the same time, financial (FCA) stated publicly that, despite the COVID-19 institutions have increased their reliance on third-
8 2020 FSOC // Annual Report party service providers for teleworking systems. among relevant agencies. These partnership efforts Greater reliance on technology, particularly across a include implementing new identifiers, developing broader array of interconnected platforms, increases and linking data inventories, and implementing the risk that a cybersecurity incident may have industry standards, protocols, and security for severe consequences for financial institutions. For secure data sharing. The Council also recommends example, recent FRBNY analysis details how the that member agencies support adoption and use of impairment of payment systems at any of the five standards in mortgage data, including consistent most active U.S. banks would result in significant terms, definitions, and data quality controls, which spillovers to other banks. Meanwhile, the rapid shift will make transfers of loans or servicing rights less towards working from home has also increased disruptive to borrowers and investors. The Council cybersecurity risks in the financial sector. Market recommends that member agencies continue to participants have observed malicious actors’ use of work to harmonize domestic and global derivatives COVID-19 themed phishing attacks to increase their data for aggregation and reporting, and ensure success at compromising less secure home networks. that appropriate authorities have access to trade repository data needed to fulfill their mandates. The Council recommends that federal and state agencies continue to monitor cybersecurity risks Financial Innovation and conduct cybersecurity examinations of financial Financial innovation can offer substantial benefits to institutions and financial infrastructures to ensure, consumers and businesses by meeting unfulfilled or among other things, robust and comprehensive emerging needs or by reducing costs, but it may also cybersecurity monitoring, especially in light of new create new risks and vulnerabilities. For example, risks posed by the pandemic. At the same time, the there has been an increase in the number and type unique and complex threats posed by cyber risks of digital assets with many increasing in value. Much require the public and private sectors to cooperate like traditional assets, digital assets can also be to identify, understand, and protect against these subject to operational and counterparty risks that risks. The Council supports the continued use and could prove disruptive to users and the digital asset enhancement of public-private partnerships to ecosystem as a whole. identify cybersecurity risks and to mitigate them. The Council also supports agency efforts to increase In addition, financial firms’ rapid adoption of the efficiency and effectiveness of cybersecurity fintech innovations in recent years may increase examinations across the regulatory authorities. operational risks associated with financial institutions’ use of third-party service providers; if Data Gaps and Challenges critical services are outsourced, operational failures The 2008 financial crisis revealed gaps in the data or faults at a key service provider could disrupt needed for effective oversight of the financial the activities of multiple financial institutions or system and in internal firm risk management and financial markets. reporting capabilities. Since the crisis, important steps have been taken, including developing and The Council encourages agencies to continue to implementing new identifiers for financial data. monitor and analyze the effects of new financial Significant gaps remain, however, as some market products and services on consumers, regulated participants continue to use legacy processes that entities, and financial markets, and evaluate their rely on data that are not aligned to definitions from potential effects on financial stability. The Council relevant consensus-based standards. Gaps and legacy encourages continued coordination among processes inhibit data sharing. federal and state financial regulators to support responsible financial innovation and The Council recommends that regulators and competitiveness, promote consistent regulatory market participants continue to work together to approaches, as well as to identify and address improve the coverage, quality, and accessibility potential risks that arise from such innovation. of financial data, as well as improve data sharing
Executive Summary 9
3 Financial Developments
3.1 Household Finance
Prior to the onset of the COVID-19 pandemic, 3.1.1 Household Debt as a Percent of Disposable Personal Income households were generally in sound financial 3.1.1 Household Debt as a Percent of Disposable Personal Income condition. In contrast to the lead up to the 2008 Percent As Of: 2020 Q2 Percent financial crisis, debt levels, both in real terms 160 160 Other Household Credit and as a percentage of disposable income, were Consumer Credit Mortgages relatively low, and household credit growth was 120 120 concentrated in prime borrowers. Additionally, household debt service ratios and delinquency 80 80 rates were low. Disruptions to economic activity caused by the pandemic introduced 40 40 considerable stress to households, however. The unemployment rate surged from 3.5 0 0 percent in February to a record high of nearly 1995 1998 2001 2004 2007 2010 2013 2016 2019
15 percent in April. Since then, extraordinary Source: BEA, Federal Note: Other Household Credit includes measures undertaken by policymakers Reserve, Haver Analytics debts of both households and nonprofits. have succeeded in arresting the decline in economic conditions, initiating a recovery and lowering the unemployment rate to 7.9 percent as of September. While considerable uncertainty remains concerning the path of the economic recovery, delinquencies may increase significantly as federal aid packages and forbearance programs phase out.
Following a sharp decline between 2008 and 2011, household debt has since grown moderately, totaling $14 trillion in the second quarter of 2020. While nominal household debt is at record levels, it remains approximately $1 trillion below 2009 levels when adjusted for inflation. In addition, the ratio of household debt to disposable personal income has trended downward in recent years, as disposable income growth has outpaced household debt growth. As of the fourth quarter of 2019, household debt as a percentage of personal income stood at 97 percent, well below the peak of 134 percent in the fourth quarter of 2007 (Chart 3.1.1). By the second quarter of 2020, household debt as a percentage of disposable income declined by eight percentage points as consumer spending
Financial Developments 11 fell dramatically and federal aid helped 3.1.2 Household Debt Service Ratio 3.1.2 Household Debt Service Ratio support incomes. The personal saving rate—a Percent As Of: 2020 Q2 Percent measure of personal savings as a percentage 14 14 of disposable personal income—spiked to 34
13 13 percent in April 2020, exceeding the previous record of 17 percent established in 1975. While 12 12 the personal saving rate has since declined to 11 11 14 percent as of September 2020, it remains well
10 10 above the 30-year average of 6.7 percent.
9 9 Rising incomes and years of low interest rates 8 8 helped keep the household debt service ratio— 1990 1994 1998 2002 2006 2010 2014 2018
Note: Ratio of debt-service payments to the ratio of debt service payments to disposable Source: Federal Reserve, disposable personal income. Seasonally personal income—near 30-year lows through Haver Analytics adjusted. Gray bars signify NBER recessions. the first quarter of 2020 and little changed since 2018, before falling to record lows in the second quarter of 2020 (Chart 3.1.2). The share of owners’ equity in household real estate 3.1.3 Owners’ Equity as Share of Household Real Estate 3.1.3 Owners’ Equity as Share of Household Real Estate continued to increase from its lows in 2012 and Percent As Of: 2020 Q2 Percent has returned to the range that prevailed in the 80 80 early 2000s (Chart 3.1.3). On net, household net worth has increased no- 70 70 tably in the last decade, driven by stock market and real estate gains; this has been particularly 60 60 true for high-net-worth and -income house- 1990-Present holds. Between the fourth quarter of 2009 and Average 50 50 the fourth quarter of 2019, households above the 80th percentile saw their net worth increase 40 40 by an annualized rate of 7.4 percent, while 1990 1994 1998 2002 2006 2010 2014 2018 households below the 80th percentile saw their Source: Federal Reserve, Haver Analytics Note: Gray bars signify NBER recessions. net worth increase by an annualized rate of 4.1 percent. Households below the 20th percentile experienced a decrease in their household net worth at an annualized rate of -1.2 percent. While household net worth declined by 5.5 per- cent in the first quarter of 2020, it has since re- bounded to pre-pandemic levels, as stock prices recovered from pandemic-related economic and financial market uncertainty.
In the last decade, consumer credit—which primarily consists of credit card debt, student loans, and auto loans—has grown at a faster pace than mortgage debt, and now accounts for about one-quarter of household debt. This growth can be attributed to increases in student loan and auto loan debt over credit card and other household debt. However, in the midst of the pandemic, total consumer credit declined
12 2020 FSOC // Annual Report as credit card balances fell by an unprecedented 3.1.4 Components of Consumer Credit $110 billion between the fourth quarter of 2019 3.1.4 Components of Consumer Credit and the second quarter of 2020. By contrast, Billions of US$ As Of: 2020 Q2 Billions of US$ auto and student loan balances were little 1750 1750 changed during this period (Chart 3.1.4). 1500 1500 Student Loans 1250 1250 Borrowers with prime credit scores have driven 1000 Credit Card Debt 1000 increases in loan balances over the last ten Auto Loans 750 750 years. As of June 2020, subprime borrowers accounted for 12 percent of loan balances, well 500 Other Household Debt 500 below the fourth quarter of 2009 peak when 250 250 subprime borrowers accounted for 21 percent 0 0 of loan balances. Total loan balances for prime 2003 2006 2009 2012 2015 2018 borrowers continued to increase throughout Source: FRBNY Consumer Credit Note: Gray bars signify Panel/Equifax, Haver Analytics NBER recessions. the pandemic, as the steady growth in mortgages more than offset the notable second quarter decline in credit card debt for this group. Alternatively, total loans for subprime 3.1.5 Change in Inquiries Relative to First Week of March 2020 borrowers ticked down in the second quarter 3.1.5 Change in Inquiries Relative to First Week of March 2020 of 2020, with mortgages, auto loans, and credit Percent As Of: 26-Jun-2020 Percent 40 40 card debt all decreasing. New Mortgages Unspecified and Other 20 20 Revolving Credit Credit standards have tightened since the start Auto Loans of the pandemic, impeding credit markets 0 0 access for some. According to the April and July 2020 Senior Loan Officer Opinion Survey -20 -20 (SLOOS), banks have, on balance, tightened standards and terms on all types of consumer -40 -40 loans since the onset of the pandemic, and the -60 -60 July survey indicated that the levels of standards Mar:2020 Apr:2020 May:2020 Jun:2020 were reportedly at the tighter end of the 2005- Source: CFPB 2020 range. In addition, according to a Federal Reserve survey of finance companies performed in early May, consumer auto lending standards at finance companies tightened somewhat relative to before the pandemic outbreak. At the same time, banks also reported that demand for credit weakened substantially in the April and July 2020 SLOOS.
Credit inquiries for new mortgages fell dramatically starting in the second week of March relative to both the first week and the trend in previous years. Inquiries for new auto loans and credit cards also fell considerably. While auto and new mortgage inquiries have largely recovered, credit card inquiries remain substantially below pre-pandemic levels (Chart 3.1.5).
Financial Developments 13 3.1.6 Percentage of Mortgages in Forbearance The economic impact of COVID-19 caused 3.1.6 Percentage of Mortgages in Forbearance strains on household finances that several Percent As Of: 27-Sep-2020 Percent government actions, including stimulus 10 10 Nonbanks payments, extended unemployment benefits, 8 Banks 8 and mortgage payment forbearance, aimed Total to alleviate. The share of mortgage loans in 6 6 forbearance increased sharply at the start of the second quarter before flattening and even 4 4 declining in recent months (Chart 3.1.6).
2 2 As of June 2020, credit record data did not
0 0 show evidence of increasing delinquencies on Mar:2020 May:2020 Jul:2020 Sep:2020 major forms of household credit during the
Source: Mortgage Bankers Association early months of the pandemic, in contrast to the U.S. experience in the Great Recession. In fact, delinquencies on household debt declined between February and June. Policy interventions at the federal, state, and local levels, which 3.1.7 Share Of Open Accounts that Transitioned to Delinquent 3.1.7 Share of Open Accounts that Transitioned to Delinquent counteracted income and employment Percent As Of: Jun-2020 Percent shocks, likely contributed to this decline in 1.5 1.5 delinquencies. Beyond direct income supports First-Lien Mortgages Student Loans such as higher unemployment insurance Credit Cards Auto Loans 1.2 1.2 benefits, these policies include programs aimed specifically at providing payment assistance 0.9 0.9 to consumers with certain types of credit. At
0.6 0.6 the same time, the stable delinquency rates can be attributed to temporary provisions 0.3 0.3 within the CARES Act mandating that loans enrolled in forbearance be reported at the 0.0 0.0 Feb:19 May:19 Aug:19 Nov:19 Feb:20 May:20 level of delinquency as of the time of the accommodation (Chart 3.1.7). Source: CFPB
The COVID-19 pandemic has led to a sharp increase in consumers seeking forbearance or loss mitigation assistance from lenders. The approximately 17,000 furnishers of information to the nationwide consumer reporting agencies vary meaningfully in their level of sophistication and ability to accurately report consumer data through this period of financial stress. In addition, as discussed in Section 3.4.5, credit scores have not generally been negatively affected by COVID-19 as a result of certain forbearance provisions in the CARES Act. Accurate information on consumer creditworthiness is important for the functioning of consumer credit markets and the broader economy. Inaccurate information in consumer credit files may impair the
14 2020 FSOC // Annual Report functioning of consumer lending and other 3.2.1.1 Nonfinancial Corporate Credit as Percent of GDP markets reliant on consumer credit report 3.2.1.1 Nonfinancial Corporate Credit as Percent of GDP information. It may be costly for furnishers Percent As Of: 2020 Q2 Percent to improve the accuracy of their reporting, 60 60 however, especially given the stress caused by the pandemic. 50 50
In the coming months, federal aid and 40 40 forbearance assistance programs are set to expire, with forbearance assistance on federal 30 30 student loans held by the Department of
Education expiring in December 2020 and 20 20 forbearance assistance for federally backed 1980 1985 1990 1995 2000 2005 2010 2015 2020 mortgages expiring in the first quarter of 2021. Source: Federal Reserve, Haver Analytics Note: Gray bars signify NBER recessions. These programs, along with analogous state government programs and voluntary programs set up by private lenders, have helped keep delinquencies low in the immediate aftermath 3.2.1.2 U.S. Nonfinancial Business Leverage of the COVID-19 pandemic. The elevated rates 3.2.1.2 U.S. Nonfinancial Business Leverage of forbearance on mortgages and other forms Ratio As Of: 2020 Q2 Ratio of household credit, however, indicate that 0.35 6 delinquencies may increase significantly as 0.30 5 programs expire. Gross Debt / Assets (left axis) 0.25 4 3.2 Nonfinancial Business Finance 0.20 3 3.2.1 Corporate Debt Nonfinancial firms entered 2020 with 0.15 2 Gross Debt / EBITDA increasingly high levels of debt, pushing the (right axis) 0.10 1 corporate debt-to-GDP ratio to record high 1990 1996 2002 2008 2014 2020 Note: Four-quarter moving average of the median ratio. levels (Chart 3.2.1.1). Debt levels were also high Source: Compustat, Haver Includes rated and unrated nonfinancial businesses. when compared to corporate earnings (Chart Analytics Gray bars signify NBER recessions. 3.2.1.2). As the economic effects of COVID-19 unfolded, corporate credit quality deteriorated as debt levels increased further and earnings declined.
Financial market conditions deteriorated sharply after the onset of the COVID-19 outbreak. Many firms accessed their lines of credit to preserve cash and liquidity given the heightened uncertainty of future revenues. These actions sharply increased bank credit exposures to nonfinancial firms in the first half of 2020. Several government relief programs have helped many businesses obtain credit and maintain operations, though considerable credit risk remains given the uncertain economic outlook. Bank lending increased
Financial Developments 15 in the second quarter of 2020 because of 3.2.1.3 Bank Business Lending Standards 3.2.1.3 Bank Business Lending Standards the increase in small business lending under Percent As Of: 2020 Q2 Percent the Small Business Administration’s (SBA’s) 100 100 Paycheck Protection Program (PPP), which Large and Middle-market Firms 75 Small Firms 75 offset the decline in lending under lines of credit. Outside of the PPP, however, the supply 50 50 of bank credit appears to have decreased as 25 25 indicated by the Federal Reserve’s SLOOS. The
0 0 percent of respondents reporting a tightening of standards reached the highest level since -25 -25 2008 (Chart 3.2.1.3). Easing Tightening Easing Easing Tightening Easing -50 -50 1992 1996 2000 2004 2008 2012 2016 2020 Note: Represents net percentage of banks reporting At the height of the March 2020 COVID-19 Source: Federal Reserve Senior tightening standards for C&I loans. Large and middle- market firms are those with annual sales of $50 million market stress, corporate bond issuance came Loan Officer Opinion Survey or more. Gray bars signify NBER recessions. to a near-halt as secondary market liquidity dried up and investment grade corporate credit spreads surged to levels not seen since the 2008 financial crisis (Chart 3.2.1.4). However, 3.2.1.4 Investment Grade Corporate Bond Spreads 3.2.1.4 Investment Grade Corporate Bond Spreads market conditions improved following the Percent As Of: 30-Sep-2020 Percent announcement of the Federal Reserve’s Primary 10 10 BBB US Corporate Index Market and Secondary Market Corporate Credit Facilities. These facilities led to a significant 8 Single-A US Corporate Index 8 AA US Corporate Index Hundreds tightening in credit spreads and bid-ask spreads 6 6 for investment grade corporates. Financing conditions were further supported by the 4 4 Federal Open Market Committee’s (FOMC’s) decision to reduce the target federal funds rate 2 2 to near zero percent, allowing investment grade firms to issue new debt at historically low yields. 0 0 2005 2007 2009 2011 2013 2015 2017 2019 Source: Ice Data Indices, Note: The ICE BofA Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all Consistent with more accommodative financing ICE BofA US, FRED bonds in a given rating category and a spot Treasury curve. conditions, issuances of investment grade corporate bonds hit a record $298 billion in April, and in the first nine months of 2020, gross issuance of investment grade corporate 3.2.1.5 Gross Issuance of Corporate Bonds bonds totaled $1.6 trillion compared to 3.2.1.5 Gross Issuance of Corporate Bonds Trillions of US$ As Of: Sep-2020 Trillions of US$ $1.1 trillion for all of 2019 (Chart 3.2.1.5). 2.5 2.5 Corporations raising cash buffers, paying down High-Yield Investment Grade drawn revolving credit lines, and refinancing 2.0 2.0 existing debt at more favorable interest rates
1.5 1.5 were primarily responsible for the record level of issuances. While share repurchases and 1.0 1.0 dividend distributions still account for a sizeable portion of corporations’ use of proceeds, 0.5 0.5 during the first half of 2020, nonfinancial
0.0 0.0 corporations increased their holdings of 2006 2008 2010 2012 2014 2016 2018 2020 YTD domestic bank deposits (checking and time Note: Includes all non-convertible corporate debt, Source: Refinitiv, MTNs, and Yankee bonds, but excludes all issues deposit accounts) and currency by $580 billion, SIFMA with maturities of 1 year or less and CDs.
16 2020 FSOC // Annual Report a 40 percent increase relative to the fourth 3.2.1.6 High-Yield Corporate Bond Spreads quarter of 2019. 3.2.1.6 High-Yield Corporate Bond Spreads Percent As Of: 30-Sep-2020 Percent 25 25 Spreads on high-yield corporate bonds, which Single-B US Corporate Index BB US Corporate Index were at very low levels prior to the COVID-19 20 20 pandemic, increased significantly during the March 2020 market stress (Chart 3.2.1.6). The 15 15 stress observed in the high-yield corporate bond market effectively shut down the primary 10 10 market and according to Standard & Poor’s 5 5 Leveraged Commentary & Data (S&P LCD), only five bonds were priced in March, raising a 0 0 total of $4.2 billion. This represents a decline 2005 2007 2009 2011 2013 2015 2017 2019 Source: Ice Data Indices, Note: The ICE BofA Option-Adjusted Spreads (OASs) are the of 86 percent from February 2020, when calculated spreads between a computed OAS index of all ICE BofA US, FRED bonds in a given rating category and a spot Treasury curve. approximately $30 billion was raised, and a decline of 81 percent from March 2019, when $22 billion was raised. High-yield spreads have since compressed considerably but remain 3.2.1.7 Leveraged Loan Spreads above pre-pandemic levels. Nevertheless, 3.2.1.7 Leveraged Loan Spreads the decline in risk-free rates has meant that Percent As Of: 30-Sep-2020 Percent 12.5 12.5 effective yields on high-yield corporate bonds are now at or near pre-pandemic levels. As of
September 30, 2020, the effective yield on the Hundreds 10.0 10.0 Hundreds ICE BofA US High Yield Index was 5.8 percent compared to 5.7 percent on September 30, 7.5 7.5 2019. With the return of more normal market conditions, high-yield borrowers returned to 5.0 5.0 the market and in the first nine months of 2020, gross issuance of high-yield corporate 2.5 2.5 bonds totaled $325 billion compared to $279 2011 2013 2015 2017 2019 billion for all of 2019. Although most high- Note: Spread-to-maturity for syndicated loans Source: S&P LCD yield bonds are not eligible for the Federal included in the S&P LCD Leveraged Loan Index. Reserve’s programs or facilities, much of the improvement in pricing is attributed to the implementation of these programs and to the low interest rate environment. 3.2.1.8 Institutional Leveraged Loan Issuance 3.2.1.8 Institutional Leveraged Loan Issuance Billions of US$ As Of: 30-Sep-2020 Billions of US$ After a few years of robust growth, issuance of 100 500 2020 Monthly Issuance (left axis) leveraged loans came to a halt in March, and 2016-2019 Monthly Average spreads widened significantly, peaking at over 80 Issuance (left axis) 400 2016-2019 Average Cumulative 1,000 basis points in late March. Since then, Issuance (right axis) spreads have compressed by over 500 basis 60 2020 Cumulative Issuance 300 (right axis) points to 493 basis points as of September 30, 40 200 2020 (Chart 3.2.1.7). In contrast to the record level of issuance in the investment grade and 20 100 high-yield corporate bond markets, issuance in the leveraged loan market remains subdued 0 0 relative to pre-pandemic levels (Chart 3.2.1.8). Jan Mar May Jul Sep Nov Demand from collateralized loan obligations Source: S&P LCD
Financial Developments 17 (CLOs), which purchased approximately 60 3.2.1.9 Nonfinancial Corporations Liquid Assets 3.2.1.9 Nonfinancial Corporations Liquid Assets percent of the syndicated loan issuances in Percent of Total Assets As Of: 2020 Q2 Percent of Total Assets 2019, waned in 2020. As of September 30, 2020, 9 9 CLO volumes totaled $60 billion year-to-date, 8 8 a 33 percent decline compared to the first nine
7 7 months of 2019.
6 6 Some factors mitigate the burden of the debt 5 5 accumulated by corporations. Low interest rates 4 4 support interest coverage ratios for nonfinancial 3 3 firms. In addition, firms have accumulated 2 2 record levels of liquid assets which they can use 1980 1985 1990 1995 2000 2005 2010 2015 2020 as a buffer against the drop in revenues (Chart Note: Liquid assets includes foreign deposits, checkable deposits and Source: Federal Reserve, currency, time and savings deposits, money market fund shares, security repurchase agreements, debt securities, and mutual fund 3.2.1.9). The immediate refinancing risk is Haver Analytics shares. Gray bars signify NBER recessions. limited, and the high-yield debt accounts for 27 percent of U.S. nonfinancial debt maturing through 2021 compared to 56 percent of U.S. nonfinancial debt maturing in 2024 (Chart 3.2.1.10 Maturity Profile of U.S. Nonfinancial Corporate Debt 3.2.1.10 Maturity Profile of U.S. Nonfinancial Corporate Debt 3.2.1.10). However, nonfinancial corporations Billions of US$ As Of: July-2020 Billions of US$ with lower revenues and additional debt 1200 1200 Speculative Grade outstanding may face increased constraints 1000 Investment Grade 1000 in deleveraging as higher debt servicing requirements may constrain future expansion. 800 800 Despite these mitigating factors, the COVID-19 600 600 pandemic has led to a contraction in economic
400 400 activity and corporate profits. This contrac- tion has resulted in a sharp deterioration in 200 200 the credit quality of nonfinancial businesses. 0 0 During the first nine months of 2020, approxi- 2020 2021 2022 2023 2024 2025 mately $2 trillion of U.S. nonfinancial corpo- Source: S&P Global Note: Includes bonds, loans, and revolving credit rate debt was downgraded by Standard & Poor’s Ratings Research facilities that are rated by S&P Global Ratings. (S&P), with the majority of these downgrades occurring in March, April, and May. The CO- VID-19 pandemic has also negatively impacted credit performance. Default rates on leveraged loans and corporate bonds have increased nota- bly from the pre-crisis lows, though they are still below those observed during the 2008 financial crisis. Amid uncertainty about the pandemic and future economic growth, downside risks for business credit quality and solvency remain.
18 2020 FSOC // Annual Report Box A: Nonfinancial Corporate Credit: Financial Market Fragilities and the COVID-19 Pandemic
Prior to the COVID-19 pandemic, U.S. corporate debt enterprises (SMEs), which employ close to 50 percent ratios were elevated, leaving firms more vulnerable of U.S. workers, have limited access to capital to an earnings shock. During the early phase of markets, and are more vulnerable to economic the crisis, debt ratios increased even further as shocks. corporations drew down revolving credit facilities to cover emergency liquidity and operating needs, while A.1 U.S. Corporate Defaults A.1 U.S. Corporate Defaults earnings declined. Billions of US$ As Of: 2020 Q3 Percent 200 20 In response to the crisis, the Federal Reserve and Default Rate (right axis) Total Defaulted Debt (left axis) Treasury launched a series of corporate lending 160 16 facilities to enable markets to function more effectively. Following these extraordinary actions, corporate 120 12 bond issuance surged to record levels, credit spreads 80 8 narrowed, and bid-ask spreads tightened (see Section 3.2.1). Looking forward, there is significant 40 4 uncertainty in the corporate sector outlook. In an 0 0 adverse scenario, corporate defaults and bankruptcies 2007 2009 2011 2013 2015 2017 2019 could increase significantly. Additionally, significant Source: Moody's Note: Issuer weighted four quarter trailing default debt overhang and an acceleration in credit rating Investors Service, OFR rate for speculative grade U.S. corporates. downgrades could lead to increased debt servicing costs, limiting efficient allocation of capital and Business bankruptcy filings are also increasing, with dragging on the economic recovery. Chapter 11 business filings exceeding 5,500 year-to- date through September, compared to 4,100 over the Rising defaults and bankruptcies among same period in 2019 (Chart A.2). While the path of high-yield borrowers the economic recovery remains uncertain, the pace In 2020 an increasing number of high-yield firms of filings may accelerate going forward as some defaulted on debt obligations and filed for bankruptcy. federal assistance programs begin to roll-off. This adverse trend is expected to continue as corporate fundamentals weaken further for A.2 Chapter 11 Bankruptcy Filings companies in industries that have been particularly A.2 Chapter 11 Bankruptcy Filings challenged by COVID-19, such as the retail, airline, Count (‘000s) As Of: Sep-2020 Count (‘000s) 16 16 travel, and hospitality industries. Oct – Dec 14 Jan – Sep 14 The trailing four quarter U.S. high-yield corporate Full Year 12 12 default rate rose to 8.5 percent in the third quarter 10 10 of 2020, from 3.4 percent a year ago (Chart A.1). In 8 8 October 2020, Moody’s forecasted that the trailing 6 6 twelve month default rate will peak at 10 percent in March 2021 under its baseline scenario, lower 4 4 than the 15 percent peak in November 2009. U.S. 2 2 0 0 corporate bond and syndicated loan defaults surged 2000 2003 2006 2009 2012 2015 2018
in the second quarter of 2020, when defaults totaled Note: Annual bankruptcy filings from 2000 – 2010. $97 billion, the highest since 2009. These numbers Source: ABI, AACER Monthly bankruptcy filings from 2011 – 2020. do not include defaults of small and medium-sized
Box A: Nonfinancial Corporate Credit: Financial Market Fragilities and the COVID-19 Pandemic 19 Box A: Nonfinancial Corporate Credit: Financial Market Fragilities and the COVID-19 Pandemic
The U.S. bankruptcy system provides important A.3 U.S. Nonfinancial Corporate Downgrade-Upgrade Ratio benefits, including enabling borrowers to continue A.3 U.S. Nonfinancial Corporate Downgrade-Upgrade Ratio operating during the bankruptcy process while debts Ratio As Of: Sep-2020 Ratio 10 10 are restructured. However, a sudden wave of
bankruptcy filings could overwhelm the bankruptcy 8 8 system, resulting in congested courts and limited access to debtor-in-possession (DIP) financing. In the 6 6 event of a protracted restructuring process, firms 4 4 without access to DIP financing may have insufficient
cash flows to cover day-to-day operations. A sudden 2 2 spike in liquidations could impede the economic recovery through various channels, including 0 0 1990 1994 1998 2002 2006 2010 2014 2018 increased job cuts, reduced capital spending, and a Source: Moody’s, Note: Ratio is trailing 3-month downgrades divided tightening in lending standards for business loans due Haver Analytics, OFR by upgrades. Gray bars signify NBER recessions. to increased creditor losses. In response to these challenges, the Federal Reserve and Treasury established the Main Street Lending A.4 Fallen Angel Debt Program, a series of business lending facilities, to A.4 Fallen Angel Debt support small and medium-sized businesses. As Billions of US$ As Of: Sep-2020 Billions of US$ 250 250 of September 30, 2020, the total amount of loans
outstanding under this facility was $2.2 billion. 200 200
Credit rating downgrades further stress 150 150 corporate bond and CLO markets 100 100 Credit ratings downgrades accelerated in the spring
as corporate credit fundamentals deteriorated. By 50 50 May 2020, the rolling 3-month ratio of nonfinancial 0 0 corporate downgrades to upgrades hit 7.9, the 2001 2005 2009 2013 2017 highest level on record (Chart A.3). Ratings actions Source: BofA Global Note: Rolling three months beginning in March 2020. Includes Research, ICE Data financial issuers. Fallen angels above refer to issuers stabilized in the summer of 2020, and the ratio of Services, OFR previously included in the BofA U.S. Corporate Index. downgrades to upgrades fell to slightly above one for the three months ending September 2020. A large percentage of these recent downgrades pertain to “fallen angels,” issuers downgraded from investment grade to high-yield. According to the ICE BofA U.S. Corporate Index, fallen angels totaled $250 billion year-to-date as of September, significantly exceeding annual levels over all prior years (Chart A.4). The Federal Reserve and Treasury established the Primary and Secondary Market Corporate Credit Facilities to provide a funding backstop for eligible corporate debt and to support market liquidity for
20 2020 FSOC // Annual Report 3.2.2 Equities The U.S. equity market entered 2020 on the heels of one of its best annual gains in the last two decades. Despite investor concern over global trade policy and the sustainability of the longest U.S. economic expansion on corporate debt. These facilities were subsequently record, the S&P 500 climbed 29 percent in 2019. Led by expanded to include certain fallen angel debt, a sharp rise in tech stocks, the U.S. index outpaced most which has helped restore investor confidence and of its global peers, with benchmarks in Japan, Europe, mitigate disruptions resulting from credit rating and China rising 18 percent, 25 percent, and 22 percent downgrades. in 2019, respectively. Emerging market stocks also Another concern regarding downgrades involves gained 15 percent on average. By the end of 2019, market corporate borrowers that rely on the syndicated analysts widely expected U.S. and global equity markets leveraged loan market. Loan-only issuers to climb higher, albeit at a slower pace, with anticipated represented 63 percent of 2019 syndicated loan support from accommodative Federal Reserve policy issuance, according to S&P LCD. In recent years, and progress towards the U.S.-China Phase One trade CLOs have been the major purchaser of leveraged agreement. loans, accounting for approximately 60 percent of primary issuance according to S&P LCD. Demand Indeed, U.S. stocks continued to hit new highs at from CLOs waned in the spring, however, as the start of 2020, with markets reacting positively to performance metrics for existing CLOs such as the official signing of a U.S.-China Phase One trade over-collateralization ratios, weighted average agreement on January 15. However, investors grew rating factors, and triple-C buckets, have been increasingly attentive to press reports describing a novel adversely affected by the recent wave of loan coronavirus outbreak originating in Wuhan, China. downgrades. As of June 2020, over 20 percent With investors citing new risks to global demand and of CLOs were failing junior over-collateralization supply chains, global stock markets endured substantial tests, according to Moody’s. Even so, the trailing volatility, beginning in Asia. As COVID-19 intensified twelve month default rate for syndicated loan and spread to Europe—and the economic impact of issuers totaled 4.6 percent as of September sustained lockdown measures became apparent—risk 2020, well below the 8.2 percent default rate sentiment took a sharply negative turn. seen in November 2009. While issuers that can access funding via the corporate bond market Selling pressure in global equity markets intensified may be less adversely impacted, issuers that rely in March as energy producers suffered from a global exclusively on the syndicated loan market may collapse in demand and Saudi Arabia and Russia failed face a tightening in financing conditions. to reach an agreement on oil output cuts, sending commodity prices sharply lower. Between February 19 and March 23, the S&P 500 fell by 34 percent, with industries most directly affected by the virus, such as air carriers, cruise lines, and energy producers, leading the decline in U.S. stocks.
During the March 2020 sell-off, the Chicago Board Options Exchange Volatility Index (VIX)—a measure of implied stock market volatility conveyed by options prices—spiked to a level exceeding that which was seen during the 2008 financial crisis, reaching 83 in mid- March after entering the year at 14 (Chart 3.2.2.1). Realized stock market volatility also exceeded 2008 levels, with the S&P 500 falling by nearly 12 percent on March 16, its largest one-day drop since 1987.
Financial Developments 21 3.2.2.1 S&P 500 Volatility The velocity of the selloff triggered market-wide 3.2.2.1 S&P 500 Volatility circuit breakers for the first time since 1997. Index As Of: 30-Sep-2020 Index These circuit breakers, revised in the aftermath 100 100 of the 2010 flash crash, were designed to halt trading if price declines reached a level that 80 80 could exhaust market volatility. Under Level 1 and Level 2 circuit breakers—which are set at 60 VIX 60 20-Year 7 percent and 13 percent of the closing price Average 40 40 for the previous day—trading pauses for 15 minutes. Under the Level 3 circuit breaker— 20 20 which is set at 20 percent—trading will halt for the remainder of the day. Between March 9 0 0 and March 18, the Level 1 circuit breaker was 2008 2010 2012 2014 2016 2018 2020 triggered four times, three of which occurred Source: Bloomberg, L.P. in the opening minutes of trading. In each instance, the resumption of trading after the halt was relatively orderly, and the Level 2 and Level 3 circuit breakers were not breached. 3.2.2.2 S&P 500 Forward Price-to-Earnings Ratio 3.2.2.2 S&P 500 Forward Price-to-Earnings P/E As Of: 30-Sep-2020 P/E During the March 2020 equity market sell-off, 30 30 the S&P 500’s 12-month forward price-to- earnings ratio—a popular valuation metric—
25 25 fell to a low of 14x, even as analysts penciled in sharp downward revisions to expected corporate profits (Chart 3.2.2.2). By the end 20 20 of March, risk sentiment began to improve amid unprecedented policy easing. In terms 15 15 of monetary policy, the Federal Reserve announced open-ended purchases of Treasury 10 10 and MBS and the purchase of corporate 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 bonds, among other extraordinary measures, Source: Bloomberg, L.P. after cutting the target federal funds rate to near zero. Regarding fiscal policy, Congress passed fiscal packages totaling approximately $2.6 trillion to support the economy and 3.2.2.3 S&P 500 1-Year Price Returns by Sector boost investor sentiment. Improved market 3.2.2.3 S&P 500 1-Year Price Returns by Sector functioning and a rebound in economic activity Percent As Of: 30-Sep-2020 Percent 50 50 in the third quarter of 2020 helped propel the broad-based recovery in global stocks. As of 25 25 September 30, the S&P 500 was up 4.1 percent on the year and its forward price-to-earnings 0 0 ratio had risen above 25x. At the sector level, the recovery was driven primarily by large-cap -25 -25 tech stocks, which analysts viewed as among the
-50 -50 main beneficiaries of changing consumer and business behaviors (Chart 3.2.2.3).
Outside of the U.S., the aggressiveness Source: Bloomberg, L.P. of countries’ economic and health policy
22 2020 FSOC // Annual Report responses to COVID-19 helped drive 3.2.2.4 Performance of Global Stock Indices differentiated price action (Chart 3.2.2.4). 3.2.2.4 Performance of Global Stock Indices For example, Asian stock markets generally Percent As Of: 30-Sep-2020 Percent 60 60 outperformed their global peers, which Euro Stoxx 50 Shanghai Composite SE Nikkei 225 S&P 500 analysts have attributed to the relatively swift 45 MSCI Emerging Markets Index 45 containment of COVID-19. As of September 30, Chinese, South Korean, and Taiwanese indices 30 30 were 5.5 percent, 5.9 percent, and 4.3 percent 15 15 higher, respectively, year-to-date. Meanwhile, the benchmark euro area stock index (Euro 0 0 Stoxx 50) was 15 percent lower on the year as of -15 -15 September 30, and bourses in Latin America— where the COVID-19 outbreak has generally -30 -30 proved more widespread and economic Jan:2019 Jul:2019 Jan:2020 Jul:2020 activity remains relatively subdued—have Source: Bloomberg, L.P. Note: Indexed to 01-Jan-2019. underperformed.
3.2.3 Nonfinancial Non-Corporate Debt Small businesses were hit particularly hard by COVID-19. In the industries most affected by COVID-19 (such as restaurants, food and beverage, and retail), roughly half of small businesses that operated in January were not open by mid-April due to shut-down orders, according to Homebase. While the share of firms in these industries that remain closed has declined substantially since then, more than 20 percent of them are still not open. The share of hourly workers working over that same period is even lower, suggesting that even among open businesses, operations remain reduced relative to their pre-COVID-19 levels.
As the uncertainty surrounding COVID-19 began and small business funding needs increased, lenders began tightening standards, increasing spreads on loans to small businesses. As a result, the SBA’s PPP was essential for the survival of many small businesses. PPP has been the COVID-19-related relief program most utilized by small businesses, and approximately two-thirds of PPP loans were originated by small and mid-sized banks. According to the SBA’s data, the PPP program supported an estimated 51 million American jobs, covering over 80 percent of small business payrolls. The funding was only designed to cover two and a half months of payroll, however. Needs are likely to increase further as many businesses remain
Financial Developments 23 closed or operate at reduced capacity. Recent 3.3.1.1 Federal Debt Held by the Public 3.3.1.1 Federal Debt Held by the Public surveys of small businesses indicate that at least Percent of GDP Percent of GDP a quarter of small businesses believe they will 225 225 need additional financial assistance in the next 200 200 six months in order for their business to survive, 175 175 CBO September 2020 Baseline Projection with about a third of firms holding less than 150 150 125 125 one month of cash on hand. 100 100 75 75 Small business loan performance has 50 50 deteriorated through the pandemic. As of 25 25 September 2020, PayNet’s measure of short 0 0 and long-term delinquencies was 18 percent 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 higher than in February and stood at levels Note: Data for fiscal years. last seen in 2011. Similarly, PayNet’s measure Source: CBO, Haver Analytics Years after 2019 are projected. of small business defaults was 43 percent higher in September than in February. Most lenders have indicated that they have modified and extended terms for many of their small 3.3.1.2 Publicly Held Treasury Securities Outstanding 3.3.1.2 Publicly Held Treasury Securities Outstanding business borrowers; thus, these numbers could Trillions of US$ As Of: Sep-2020 Trillions of US$ understate the difficulties that small businesses 25 25 are having in staying current. Bills Other Marketable Securities 20 20 3.3 Government Finance
15 15 3.3.1 Treasury Market 10 10 In early 2020, the United States was facing its deepest recession since the Great Depression. 5 5 In light of this, Congress enacted four rounds
0 0 of fiscal assistance, totaling $2.6 trillion. These 2015 2016 2017 2018 2019 2020 fiscal packages provided much-needed support
Source: Federal Reserve, Note: Other marketable securities to households, businesses, municipalities, and Haver Analytics includes notes, bonds, TIPs, and FRNs. other entities through the initial lockdowns and recovery. However, the additional spending is expected to push the 2020 primary deficit to 16 percent of GDP, a 70-year high. This will lead to a sharp increase in the amount of debt outstanding. In September 2020, the Congressional Budget Office projected that public debt will rise to approximately 110 percent of GDP in 2030 and 195 percent of GDP in 2050 (Chart 3.3.1.1).
The amount of U.S. Treasury securities outstanding grew from $17 trillion in February to $20 trillion in September, following the additional fiscal spending (Chart 3.3.1.2). New issuance has been primarily in the form of Treasury bills, which now account for 25 percent of outstanding debt compared to 15 percent
24 2020 FSOC // Annual Report at year-end 2019. In addition, the weighted 3.3.1.3 Treasury General Account Balance average maturity of marketable debt has fallen 3.3.1.3 Treasury General Account Balance from 70 months at year-end 2019 to 63 months Billions of US$ As Of: 30-Sep-2020 Billions of US$ as of September 30, 2020. The Treasury General 2000 2000 Account (TGA) at the Federal Reserve swelled 1750 1750 to $1,679 billion as of September 30, compared 1500 1500 to $370 billion at year-end 2019 (Chart 3.3.1.3). 1250 1250
The record-high TGA balance was driven by 1000 1000 several factors, including the unprecedented 750 750 size and ongoing uncertainty regarding the 500 500 timing of COVID-19-related outlays. 250 250
0 0 Between August 2019 and August 2020, foreign 2015 2016 2017 2018 2019 2020 holdings of U.S. sovereign debt increased by 2.3 Source: Federal Reserve, Haver Analytics percent to $7.1 trillion. Over this period, Japan overtook China as the largest foreign holder of U.S. sovereign debt, with $1.3 trillion in holdings as of August 2020. While China has reduced its 3.3.1.4 U.S. Treasury Yields holdings of U.S. Treasury securities in recent 3.3.1.4 U.S. Treasury Yields years, they remained fairly stable year-over-year, Percent As Of: 30-Sep-2020 Percent totaling $1.1 trillion as of August 2020. 5 5
4 4 Treasury yields declined considerably in 2020 10-Year as investors rapidly reassessed the economic 3 3 outlook in light of the COVID-19 pandemic (Chart 3.3.1.4). Between December 31, 2019 2 2 and September 30, 2020, the yield on the 2-year Treasury decreased by 145 basis points and the 1 2-Year 1 yield on the 10-year Treasury decreased by 123 0 0 basis points. Yields fell most dramatically in the 2010 2012 2014 2016 2018 2020 early days of the COVID-19 market stress, with Source: U.S. Department of the Treasury the yield on the 10-year Treasury falling by 98 basis points between February 20 and March 9. While the yield on the 10-year Treasury stabilized in the following months, it closed at a record low of 0.52 percent on August 4, 2020. 3.3.1.5 10-Year TIPS Yield and 10-Year Break Even 3.3.1.5 Ten-Year TIPS Yield and Breakeven The spread between the 2-year and 10-year Percent As Of: 30-Sep-2020 Percent Treasury yields, which briefly inverted in August 4 4 2019, remained positive in 2020, which can 3 10-Year 3 largely be attributed to the FOMC’s March 2020 Breakeven decision to cut the target range for the federal 2 2 funds rate to the zero lower bound. 1 1
Over the past two years, the yield on 10-year 0 0
Treasury Inflation-Protected Securities (TIPS) -1 -1 Treasury Inflation- has fallen considerably, from a high of 1.17 Protected Securities -2 -2 percent in November 2018 to -0.94 percent 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 as of September 30, 2020 (Chart 3.3.1.5). Source: U.S. Department Note: Breakeven represents the difference The 10-year breakeven inflation rate, which of the Treasury between the nominal and TIPS yield.
Financial Developments 25 is calculated as the difference between the 3.3.1.6 FRBNY Open Market Operations: Treasury Purchases 3.3.1.6 FRBNY Open Market Operations: Treasury Purchases nominal 10-year Treasury yield and the 10-year Billions of US$ As Of: 03-Oct-2020 Billions of US$ TIPS yield, is widely used to assess financial 400 400 market participants’ inflation expectations. This measure of inflation expectations, however, is 300 300 imperfect given that the breakeven inflation rate is also influenced by liquidity and inflation risk 200 200 premia. Prior to the COVID-19 market stress, breakeven inflation rates had been trending
100 100 downwards, with the 10-year breakeven inflation rate falling from 2.1 percent in September 2018
0 0 to 1.6 percent in mid-February 2020. During the 2008 2010 2012 2014 2016 2018 2020 COVID-19 market stress, the breakeven inflation Note: Weekly amount of Treasury securities rate fell sharply, hitting a low of 0.50 percent on Source: FRBNY purchased by the Federal Reserve Bank of New York in accordance with the FOMC directive. March 19, 2020. The breakeven inflation rate has since rebounded, rising to 1.63 percent as of September 30, 2020, which can be primarily attributed to the continued decline of the 10- year TIPS yield along with improved market functioning.
In March 2020, liquidity in the U.S. Treasury market deteriorated rapidly, severely impairing market functioning in what is typically the deepest and most liquid fixed income market in the world (see Box B). In response to this extreme stress, the FOMC directed the Open Market Trading Desk (the Desk) at FRBNY to increase the System Open Market Account holdings of Treasury securities to support the smooth functioning of markets for Treasury securities. The pace of purchases was unprecedented, with the Desk purchasing nearly $800 billion of Treasury securities in the second half of March (Chart 3.3.1.6). The Desk has since scaled back its purchases, and since mid-June, the Desk has purchased approximately $80 billion of Treasury securities per month, generally in line with the pace of previous large-scale asset purchase programs.
The credit ratings for U.S. sovereign debt published by the three largest credit rating agencies were unchanged from the previous year at AA+, Aaa, and AAA. While Fitch reaffirmed its AAA rating of U.S. sovereign debt, it revised its outlook from stable to negative, citing the deterioration in U.S. public finances and the absence of a credible fiscal consolidation plan.
26 2020 FSOC // Annual Report Box B: U.S. Treasury Market Liquidity at the Onset of the COVID-19 Pandemic
As the deepest and most liquid market in the world, B.1 Intraday Volatility for 10-Year Treasury Yields the U.S. Treasury market plays a critical role in global B.1 Intraday Volatility for 10-Year Treasury Yields financial markets. In addition to financing the U.S. federal Basis Points As Of: 30-Sep-2020 Basis Points 40 40 government, Treasury securities are used as risk-free 99th Percentile benchmarks for other financial instruments, to manage 95th Percentile 30 30 interest rate risk, and by the Federal Reserve when Intraday Volatility implementing monetary policy. Given the important role 20 20 of U.S. Treasury markets, smooth market functioning is critical to broader financial market stability and the 10 10 provisioning of credit to corporations, households, and other borrowers. 0 0 Beginning in late February, increased concerns about Jan:2019 Jun:2019 Nov:2019 Apr:2020 Sep:2020 Note: Intraday volatility calculated as daily high yield the macroeconomic consequences of the COVID-19 minus daily low yield on 10-year Treasury notes. Source: Bloomberg, L.P. Percentiles based on January 2005 – September 2020. pandemic drove Treasury yields sharply lower, with the 10-year end-of-day yield plunging from 1.59 percent on February 14 to 0.54 percent on March 9. In the first few days of the market reaction, the rapid decline in Treasury B.2 Bid-Ask Spread for 30-Year Treasury Bonds yields appeared relatively orderly. However, by mid-March B.2 Bid-Ask Spread for 30-Year Treasury Bonds liquidity conditions had deteriorated rapidly as market Basis Points As Of: 30-Sep-2020 Basis Points depth collapsed, volatility surged, and bid-ask spreads 7 7 Off-the-run (2nd) widened (Charts B.1, B.2). 6 6 Off-the-run (1st) The deterioration in liquidity conditions was particularly 5 On-the-run 5 acute for longer-dated and off-the-run Treasury securities, 4 4 which led yields on off-the-run securities to deviate 3 3 significantly from a fitted curve. In less than two weeks, 2 2 liquidity conditions in Treasury markets had deteriorated 1 1 to levels not seen since the 2008 financial crisis. In 0 0 addition, the extreme volatility triggered circuit breakers Oct:2019 Jan:2020 Apr:2020 Jul:2020 for Treasury futures, extreme deviations between Treasury Note: Represents the bid YTM minus the ask YTM for on- and off-the-run U.S. Treasury bonds. Exchange-Traded Fund (ETF) prices and their underlying Source: Bloomberg, L.P. net asset values, and deleveraging by some hedge funds. In sum, compressed and massive selling across a broad Subsequently, the Federal Reserve provided temporary spectrum of Treasury investors strained intermediaries’ supervisory relief to help incentivize dealer intermediation ability to smoothly handle record trading volumes, and to alleviate frictions in Treasury markets (see resulting in a sharp deterioration in market functioning and Section 4.1.1). Finally, the FOMC amended permanent liquidity. central bank swap lines, reintroduced temporary central On March 15, the FOMC announced it would increase bank swap lines, and established the Foreign and its holdings of Treasury securities by at least $500 billion International Monetary Authority (FIMA) repo facility over the coming months to support smooth functioning to help relieve selling pressure from foreign accounts in Treasury markets. In light of the continued strains seeking to raise dollar liquidity (see Section 3.7.1). in Treasury markets, the FOMC announced on March These steps were taken to restore Treasury market 23 that it would purchase Treasury securities in the functioning and avoid exacerbating disruptions in credit amounts needed to support smooth market functioning. markets, which could, in turn, impact access to credit
Box B: U.S. Treasury Market Liquidity at the Onset of the COVID-19 Pandemic 27 Box B: U.S. Treasury Market Liquidity at the Onset of the COVID-19 Pandemic
for corporations, households, and other borrowers. to deteriorate sufficiently to result in disorderly market The speed and scale of Federal Reserve intervention conditions, necessitating the first official intervention to stabilized Treasury market functioning by the end of restore Treasury market functioning since 1970. spring, and continued purchases have sustained this improvement with liquidity conditions returning to B.3 Primary Dealer Inventories more normal levels. B.3 Primary Dealer Inventories Billions of US$ As Of: 30-Sep-2020 Billions of US$ 350 350 Treasury Market Intermediaries Treasury Notes and Bonds 300 Treasury Bills 300 Bank affiliated broker-dealers are a key source of liquidity provision in U.S. Treasury markets. These 250 250 dealers have traditionally acted as short- to medium- 200 200 term liquidity providers, often buying or selling from 150 150 customers in large amounts, holding a portion of 100 100 these positions across days, and maintaining a 50 50
large balance sheet to support such positions. In 0 0
addition to traditional dealers, principal trading firms -50 -50 (PTFs) and other high-frequency traders (HFTs) play 2015 2016 2017 2018 2019 2020 a significant role in providing intraday liquidity to Source: FRBNY U.S. Treasury markets, with PTFs accounting for roughly 60 percent of trading volume on electronic interdealer broker platforms, which are the primary Real Money Investors and Leveraged Hedge Funds sources of price discovery for the critical on-the-run In early March, real money investors began selling off-the- segment of the Treasury market. run Treasury securities to either raise cash balances or Both traditional dealers and PTFs were under stress rebalance portfolios. Notably, foreign investors (including during March 2020. Traditional dealers entered the central banks) sold Treasuries to raise dollar liquidity, while month with already high inventory levels, making it pension funds and other asset managers sold longer- difficult for them to absorb customer sales of off- dated securities to rebalance after large price gains in the-run Treasury securities (Chart B.3). Additionally, Treasury securities and losses in equities. This heavy traditional dealers reportedly reduced market-making selling pressure by real money investors, in addition to activities in both on- and off-the-run securities after putting pressure on the Treasury cash market, likely hitting internal risk management limits under the served as a catalyst for the widening in the cash-futures sudden and intense selling of off-the-run Treasury basis, which may have precipitated the unwinding of the securities from their customers. At the same time, positions of some leveraged investors. PTFs significantly reduced their market-making activities in on-the-run securities. The extreme volatility, combined with a breakdown in typical cross- asset correlations, caused PTFs, in aggregate, to lower order book replenishment rates, which lowered market depth in Treasury futures and on-the-run or benchmark nominal coupon markets. Ultimately, the pullback by PTFs in aggregate and dealers’ inability or unwillingness to absorb record Treasury overflows caused liquidity conditions in Treasury markets
28 2020 FSOC // Annual Report 3.3.2 Municipal Bond Market Box B: U.S. Treasury Market Liquidity at the Onset of the COVID-19 Pandemic Municipal bond markets continued to experience strong retail investor demand at the start of the year, which helped drive steady net inflows into municipal bond funds and sent bond prices upward. This changed in As described in Section 3.6.2.5, hedge funds March 2020 with the onset of the COVID-19 pandemic, increased their exposures to Treasury securities as individual investors pulled money out of bonds in in the lead up to the COVID-19 pandemic. A a flight to cash. Pricing became unstable and issuers significant proportion of this growth has been responded by delaying planned bond issuances. concentrated in relative value hedge funds that seek to exploit pricing discrepancies between On April 9, 2020, the Federal Reserve announced the similar products or securities. A popular relative launch of its Municipal Liquidity Facility (MLF) to buy value strategy has been the “cash-futures basis municipal notes from eligible state and local issuers. trade,” whereby funds try to capture the spread On August 11, 2020, the Federal Reserve extended between the implied repo rate and general the termination of the MLF from September 30, 2020 collateral repo rates over the term of the trade. to year-end 2020. While some investors had already Once the basis began to widen in March and begun to return to the municipal market, the April Treasury volatility spiked, some leveraged announcement helped improve investor confidence, investors unwound their positions due to internal resulting in stabilized pricing and increased issuance. risk-management stop-outs, increased margin requirements for futures, and tightening in financing conditions. Leveraged hedge funds employing other trading strategies may have amplified long-dated Treasury yield volatility through positive feedback. Given the rapid decline in market liquidity, the selling by central banks and real money investors, in conjunction with the unwind of certain hedge fund positions, contributed to “one-way” pressure on the cash market and the widening of the cash- futures basis until late March, when the Federal Reserve began to aggressively purchase off-the- run Treasury securities, including cheapest-to- deliver securities, which are typically excluded from purchase operations.
Further Study Needed The Federal Reserve’s actions restored market functioning, yet the events of March 2020 exposed fragilities in Treasury markets that will require further study with an eye toward making future official interventions less likely. Factors that likely contributed to the breakdown in market functioning include massive selling by real and levered investors, dealer risk management and balance sheet constraints, and the rapid decline in liquidity provisioning by PTFs.
Financial Developments 29 3.3.2.1 Changes in State and Local Government Tax Revenues State and local government tax revenues 3.3.2.1 Changes in State and Local Government Tax Revenues were strong in 2019 and the first quarter of Percent As Of: 2020 Q2 Percent 2020 compared to 2018. Total state and local 12 12 government tax revenues in the second half 9 9 of 2019 were 6.0 percent higher than in the second half of 2018 (Chart 3.3.2.1). However, 6 6 delayed tax filings and business closures due 3 3 to COVID-19 negatively affected tax revenues
0 0 in the second quarter of 2020, with economic contraction expected to hold down tax revenues -3 -3 for the rest of the year. -6 -6 1998 2001 2004 2007 2010 2013 2016 2019 Municipal bond ratings continued to improve Note: Data represents year-over-year percentage change. Revenue Source: U.S. Census measures includes revenues from property, individual income, corporate in 2019, and state and local tax revenues for the Bureau, Haver Analytics income, and sales taxes. Gray bars signify NBER recessions. full year were 7.0 percent higher than in 2018. State reserve fund balances across the country increased in 2019, with the median rainy- day fund balance as a share of general fund 3.3.2.2 Municipal Bond Mutual Fund Flows 3.3.2.2 Municipal Bond Mutual Fund Flows expenditures rising to 7.8 percent, based on Billions of US$ As Of: Sep-2020 Billions of US$ data aggregated from all 50 state budget offices. 30 30 However, by the second quarter of 2020, states 20 20 began to draw down rainy-day balances to offset 10 10 falling revenues. 0 0
-10 -10 Municipal bond funds experienced record
-20 -20 net inflows in 2019 and the first two months
-30 -30 of 2020. In 2019, net fund inflows totaled $93 billion, compared to $4.2 billion of net inflows -40 -40 for 2018 (Chart 3.3.2.2). In March and April, -50 -50 2010 2012 2014 2016 2018 2020 however, investors responded to the COVID-19 pandemic by withdrawing $45 billion from Source: ICI, Haver Analytics Note: Net fund flows. municipal bond funds, with market analysts pointing to a substantial flight into money market funds. This was followed by a net inflow of $43 billion between May and September 2020 3.3.2.3 Municipal Bonds to U.S. Treasuries as market conditions stabilized. Cumulative 3.3.2.3 Municipal Bonds to U.S. Treasuries net flows totaled $18 billion for the first Percent As Of: 25-Sep-2020 Percent 600 600 nine months of 2020, a decline of 74 percent 30-Year AAA compared to the first nine months of 2019. 500 10-Year AAA 500 5-Year AAA 400 400 During the market displacement from mid- March through April, diverging municipal 300 300 bond and Treasury bond prices resulted in the 200 200 ratio of 10-year AAA-rated general obligation to
100 100 10-year Treasury yields spiking to 340 percent (Chart 3.3.2.3). By September 25, 2020, this 0 0 municipal-to-Treasury ratio dropped to 124 2005 2008 2011 2014 2017 2020
Note: Percentage of municipal yields against equivalent Treasury percent—still well above the historical norm of Source: Municipal Market yields. Bloomberg's BVAL AAA Benchmark replaced MMA as the Advisors, Bloomberg, L.P. provider for municipal yields on September 1, 2010. 98 percent.
30 2020 FSOC // Annual Report Annual municipal debt issuance was up 3.3.2.4 Municipal Bond Issuance 23 percent in 2019 over 2018, and monthly 3.3.2.4 Municipal Bond Issuance municipal bond sales continued at above Billions of US$ As Of: Sep-2020 Billions of US$ 600 600 average levels at the start of 2020 (Chart Private Placement 500 General Obligation 500 3.3.2.4). In March, however, primary market Revenue issuance fell 53 percent from the previous 400 400 month as issuers withdrew scheduled bond sales in response to significantly lower retail 300 300 demand. Municipal debt issuance recovered in 200 200 the following months and as of September 2020, 100 100 year-to-date issuances totaled $347 billion, a 24 percent increase relative to the same period in 0 0 2006 2008 2010 2012 2014 2016 2018 2020 2019. In particular, taxable issuance increased YTD sharply, driven by overall low interest rates and Source: Thomson Reuters, SIFMA Note: Excludes maturities of less than 13 months. changes in the tax code that no longer allow tax-exempt advance refundings.
Over the medium-term, expected impacts of the COVID-19 crisis include lower state and local revenues and increased debt obligations and debt service. Longer-term credit weaknesses in the area of pension and retiree health care liabilities remain concerns in the municipal market. Despite these challenges, credit rating agencies have taken relatively few negative rating actions against municipal debt. S&P and Moody’s only downgraded approximately one percent of the municipal borrowers they rate in the second quarter of 2020.
The fiscal crisis of Puerto Rico remains distinctive in a sector with few defaults historically. The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), enacted in June 2016, provided for the establishment of the Financial Oversight and Management Board for Puerto Rico (the FOMB) and a resolution process for Puerto Rico’s $74 billion in public sector debt (excluding pension liabilities). In 2017, the Commonwealth and four of its instrumentalities filed to pursue debt restructuring under Title III of PROMESA, followed by a Title III filing of the Puerto Rico Public Buildings Authority (PBA) in September 2019. The Puerto Rico Urgent Interest Fund Corporation—a government-owned corporation created to securitize Puerto Rican sales and use tax
Financial Developments 31 proceeds—is the only Commonwealth entity to have reached a resolution of its debt obligations.
In May 2019, the Puerto Rico Electric Power Authority (PREPA) entered into a restructuring support agreement to restructure $8.9 billion of the authority’s bonded debt. As of November 2020, court confirmation of the agreement is pending. PREPA’s 2020 Fiscal Plan requires it to cede its main operating assets to private service providers by the second half of 2022.
In February 2020, the FOMB filed an amended Plan of Adjustment to restructure more than $50 billion of pension liabilities and $35 billion of debt and other claims against the Commonwealth, PBA, and the Employee Retirement System. If approved, the plan would reduce $35 billion of debt and other claims by almost 70 percent to approximately $11 billion. Weak structural reform execution and revenue impacts of COVID-19, however, have substantially reduced the Commonwealth’s forecasted surplus from the 2019 Fiscal Plan, a key input to the Plan of Adjustment. The Commonwealth’s 2020 Fiscal Plan requires fiscal measures and structural reforms expected to contribute to an average annual pre-debt service surplus of $578 million over five years, down from an expected $2.1 billion in the 2019 Fiscal Plan
In fiscal year 2020, the Commonwealth’s annual general fund collections fell 22 percent from the previous year. The 2020 Fiscal Plan forecasts that a lack of robust structural reforms, rising healthcare costs, and the phase-out of federal aid will lead to annual deficits starting in 2032—six years earlier than projected in the 2019 plan.
While federal disaster-related funds are having an ameliorative effect, Hurricane Maria highlighted weaknesses in the island’s electric, water, and transport infrastructure that undermine the island’s manufacturing base and feed outmigration.
32 2020 FSOC // Annual Report Box C: Finances of State and Local Authorities and the COVID-19 Pandemic
Most state and local governments entered 2020 with Challenges in the current environment increased reserves and record-high rainy-day funds. Despite improved primary and secondary market Despite these strengths, municipal markets became conditions, municipal fundamentals remain stressed. increasingly volatile as the pandemic worsened In particular, declining tax revenues and increased in March. Mutual fund investors pulled over $41 pandemic-related spending pose challenges for billion of assets out of the market in less than three state governments. States derive the bulk of their weeks. Withdrawals were accompanied by widening tax revenue from individual income and sales taxes, spreads, hindering state and local governments’ and the Tax Policy Center estimates total tax revenue ability to borrow in a time of delayed and lower tax shortfalls of $75 billion and $125 billion for fiscal years revenue. Between March 9 and March 20, state 2020 and 2021, respectively. Tourism-dependent and local governments sold only $6 billion of the and oil-producing states face additional headwinds $16 billion in bonds they sought to issue, and most given lower tax revenues. Ongoing fiscal negotiations new issues were canceled due to collapsed investor also add uncertainty, as federal aid is a significant demand. Market functioning deteriorated to the point source of state budget funds. Most states have where buyers and sellers had difficulty determining balanced budget requirements, making it difficult prices, and state and local authorities were effectively to fund spending obligations and investment during shut out of the primary market. times of decreased tax revenue. Pension liabilities, In response to stressed markets, the Federal which were already underfunded, are under pressure Reserve extended asset eligibility for the Money as investment portfolios try to recoup losses from Market Mutual Fund Liquidity Facility (MMLF) and the market volatility. In light of the deteriorating outlook Commercial Paper Funding Facility (CPFF) to include for revenues, many states are already looking to cut certain short-term municipal securities on March expenditures, tap reserves, and issue debt/notes to 23. On April 9, the Federal Reserve announced the bridge deficits and address short-term liquidity needs. establishment of the MLF, which would purchase up to $500 billion of short-term notes directly from eligible state and local issuers. Markets responded positively to this announcement; outflows slowed in April and municipal mutual funds have received consecutive weeks of positive inflows since early May. Participation in the MLF remains limited, however, with only the state of Illinois and the Metropolitan Transportation Authority of New York tapping the facility for a total outstanding amount of $1.7 billion as of September 30, 2020.
Box C: Finances of State and Local Authorities and the COVID-19 Pandemic 33 Box C: Finances of State and Local Authorities and the COVID-19 Pandemic
In contrast to state governments, local governments 2020 and 2021. According to the National League generate the majority of revenue through property of Cities and the National Association of Counties, taxes, insulating them from immediate declines in localities (such as cities, towns, and villages) are sales and income tax revenues (Charts C.1, C.2). estimated to see total revenue losses of $134 billion and $117 billion in fiscal years 2020 and 2021, C.1 Breakdown of State Tax Revenues respectively, while counties are estimated to lose C.1 Breakdown of State Tax Revenues $114 billion in revenue from fiscal year 2020 to 2021. As Of: 2019 While the estimated $365 billion in lost revenues does not take into account offsets from CARES 9% 5% Act funding, it also does not consider additional 2% expenditures or the impact of deferring pension Other Corporate Income contributions. 47% 38% Property Sales Some state and local governments are deferring Individual Income or reducing scheduled pension payments in 2020 to cover budget shortfalls caused by constrained budgets. Deferring pension contributions may not materially impact creditworthiness or future pension payments for those municipalities with well-funded Source: U.S. Census Bureau pension plans; however, a number of pension funds were in materially underfunded positions prior to the COVID-19 pandemic, and deferring contributions C.2 Breakdown of Local Tax Revenues C.2 Breakdown of Local Tax Revenues could have serious implications for the sustainability As Of: 2019 of these plans. As of fiscal year 2018, 16 pension funds in seven states were less than 50 percent 1% 5% 5% funded, with unfunded liabilities totaling nearly $270 18% Other billion (Chart C.3). Corporate Income Property 72% C.3 Liabilities of Severely Underfunded Public Pension Plans Sales C.3 Liabilities of Severely Underfunded Public Pension Plans Individual Income Billions of US$ As Of: 2018 Percent 300 100 Local unfunded liability (left axis) 250 State unfunded liability (left axis) 90
200 80
Source: U.S. Census Bureau 150 70 Contribution rate Nevertheless, the potential for declines in property 100 (right axis) 60 tax revenues, as well as potential reductions in 50 50 federal and state aid, constitute a risk for local authorities in the coming years, given the inherent 0 40 2001 2003 2005 2007 2009 2011 2013 2015 2017 lag in property tax assessment and collections. Note: Includes state and local pension plans with UAAL below 50 percent as of 2018. Contribution rate calculated as the weighted Moreover, municipalities that are reliant on sales and Source: publicplansdata.org average contribution as a percent of actuarially required contribution. income taxes, such as New York City, are expected to see material declines in revenues for fiscal years
34 2020 FSOC // Annual Report 3.4 Financial Markets 3.4.1.1 CP Outstanding by Issuer Type 3.4.1.1 CP Outstanding by Issuer Type 3.4.1 Wholesale Funding Markets: Unsecured Trillions of US$ As Of: Sep-2020 Trillions of US$ 2.5 2.5 Borrowing Other Foreign Nonfinancial Commercial Paper 2.0 Foreign Financial 2.0 Domestic Nonfinancial The commercial paper (CP) market is an Domestic Financial important source of unsecured funding for 1.5 Asset-Backed 1.5 financial and nonfinancial companies to meet current operating needs. CP is a financial 1.0 1.0 instrument with maturity up to 270 days, and 0.5 0.5 firms generally rollover outstanding balances.
Thus, companies relying on the CP market for 0.0 0.0 funding are susceptible to changing market 2001 2004 2007 2010 2013 2016 2019 conditions during the rollover period. Source: Federal Reserve, Note: Not seasonally adjusted; domestic includes CP Haver Analytics issued in the U.S. by entities with foreign parents.
Total CP outstanding was $957 billion at the end of September 2020, down from $1,075 billion in September 2019 (Chart 3.4.1.1). CP 3.4.1.2 CP Issuance by Issuer Type and Rating outstanding issued by financial firms declined 3.4.1.2 CP Issuance by Issuer Type and Rating to $533 billion in September 2020, from $552 Billions of US$ As Of: Sep-2020 Billions of US$ billion in September 2019. These issuers 60 60 AA ABCP represent 56 percent of the amount outstanding 50 AA Financial 50 A2/P2 Nonfinancial compared to 51 percent outstanding the year AA Nonfinancial prior. Nonfinancial firm issuers, which include 40 40 industrial firms, service firms, and public 30 30 utilities, among others, account for 19 percent 20 20 of the balances outstanding as of September 2020. Nonfinancial issuers saw a $100 billion 10 10 decline, or 35 percent, in CP balances over 0 0 the one-year period. Most of the decline Jan:2019 May:2019 Sep:2019 Jan:2020 May:2020 Sep:2020 occurred in the second quarter of 2020 when Source: Federal Reserve, Note: Monthly average. nonfinancial CP balances fell by $69 billion. Haver Analytics ABCP, which accounted for the remaining 25 percent of CP outstanding, rose 0.5 percent over the past year, totaling to $241 billion at the end of September 2020. Unlike 2007-2009, ABCP issuers were able to issue new CP or rollover CP balances during the COVID-19 market stress (Chart 3.4.1.2).
Nonfinancial companies have few options other than CP and bank revolving credit facilities for short-term financing. A freezing of the CP market for nonfinancial companies is a risk for these firms and for the banks that provide revolving credit facilities that backstop CP programs.
Financial Developments 35 3.4.1.3 CP Outstanding & MMF Holdings In mid-March, the U.S. CP market was severely 3.4.1.3 CP Outstanding & MMF Holdings disrupted amid economic uncertainty arising Billions of US$ As Of: Sep-2020 Billions of US$ 1200 450 from the COVID-19 pandemic. Prime MMFs— which are significant purchasers of CP—sought Commercial Paper 1150 Outstanding (left axis) 400 to reduce CP holdings to raise cash in response to actual and expected investor redemptions 1100 350 (Chart 3.4.1.3). Dealers faced balance 1050 300 sheet limits and were unable or unwilling to intermediate in the secondary market. In 1000 250 addition, the Risk Management Association’s Money Market Fund Commercial 950 200 Quarterly Aggregate Data Survey shows that Paper Holdings (right axis) securities lending cash collateral reinvestment 900 150 Jan:2017 Jan:2018 Jan:2019 Jan:2020 accounts—which are also significant purchasers
Source: Federal Reserve, SEC Form N-MFP, Haver Analytics of CP—reduced their holdings by 29 percent in the first quarter of 2020 (see Section 3.4.2). Survey data does not provide information concerning the amount of ABCP held by these accounts. 3.4.1.4 Three Month CP Interest Rate Spreads 3.4.1.4 Three Month CP Interest Rate Spreads Percent As Of: 30-Sep-2020 Percent The resulting lack of demand for new 4 4 unsecured exposures, and the forced selling A2/P2-Rated Nonfinancial AA-Rated ABCP of short-term assets, propelled credit spreads 3 AA-Rated Financial 3 AA-Rated Nonfinancial and absolute yields to rise relative to less-risky benchmarks, such as the effective federal funds 2 2 rate, the overnight index swap (OIS) rate, and SOFR. LIBOR also widened relative to less-risky 1 1 benchmark rates. The spread between the 90- day AA Nonfinancial CP rate and the OIS rate 0 0 reached a peak of 210 basis points on March 26, Jan:2019 Jun:2019 Nov:2019 Apr:2020 Sep:2020 a level not seen since the 2008 financial crisis.
Source: FRBNY, Bloomberg L.P., Note: Spread to 3-Month The spread on the 90-day A2/P2 Nonfinancial Haver Analytics, OFR Overnight Index Swap (OIS) rate. CP rate peaked at 376 basis points on March 20 (Chart 3.4.1.4).
Many firms reportedly were unable to issue 3.4.1.5 Weekly CP Issuance by Tenor CP or to only issue at a very high yield, thus 3.4.1.5 Weekly CP Issuance by Tenor increasing their rollover risk and reducing Billions of US$ As Of: 25-Sep-2020 Billions of US$ 120 120 the ability of CP to support their short-term 10+ Days funding and liquidity needs. Issuances with 100 5-9 Days 100 1-4 Days tenors of less than four days also markedly 80 80 increased in March (Chart 3.4.1.5).
60 60 In mid-March, the Federal Reserve took a series 40 40 of actions to address the dislocation in the
20 20 wholesale funding markets by announcing the establishment of lending facilities under section 0 0 13(3) of the Federal Reserve Act, including Jan:2019 Jul:2019 Jan:2020 Jul:2020 the CPFF on March 17 and the MMLF on Source: Federal Reserve, Haver Analytics Note: Weekly average. March 18. The former allows highly rated U.S.
36 2020 FSOC // Annual Report CP issuers to sell CP to the Federal Reserve’s 3.4.1.6 Commercial Bank Deposit Growth special purpose vehicle. The latter makes loans 3.4.1.6 Commercial Bank Deposit Growth available to U.S. depository institutions and Percent As Of: 30-Sep-2020 Percent BHCs to finance their purchases of certain 30 30 types of assets from MMFs (see Section 4.1). 20 20 The MMLF helped support liquidity in the Total Deposits 10 10 markets for the assets held by MMFs. 0 0
Outflows from prime MMFs gradually reversed -10 -10 following the announcement of the MMLF Large Time Deposits and CPFF, contributing to improvements in -20 -20
CP market condition and potentially reducing -30 -30 the usage of the bank backstop facilities. 2007 2009 2011 2013 2015 2017 2019 Outstanding amounts under the MMLF and Source: Federal Reserve, Haver Analytics Note: Year-over-year percentage change. the CPFF were $7.1 billion and $.03 billion, respectively, at the end of September 2020. This is down from a peak of $54.1 billion on April 6, 2020, under the MMLF and $4.3 billion on May 13, 2020, under the CPFF.
Bank Deposits Deposits can form a stable source of funding for banks, although the stability of different types of deposits can vary. Brokered certificates of deposit and large denominated deposits are considered riskier sources of funding because they can be more vulnerable to changes in short-term interest rates if the customer finds a more appealing rate elsewhere.
In the first nine months of 2020, total deposits at U.S. commercial banks grew by $2.5 trillion to $16 trillion at the end of September. Large time deposits, which include wholesale certificates of deposit (CDs), declined 15 percent in the first nine months of 2020 to $1.6 trillion and 11 percent on a year-over-year basis (Chart 3.4.1.6). In the first half of 2020, estimated insured deposits at domestic office banks increased by over $1 trillion, and stood at $8.8 trillion at the end of June 2020.
3.4.2 Wholesale Funding Markets: Secured Borrowing Repo Markets The repo market is an integral part of the STFMs, providing secured, short-term, marked- to-market funding against various forms of securities collateral. SOFR, the ARRC’s
Financial Developments 37 preferred alternative to LIBOR, is a broad 3.4.2.1 FICC Repo Balances and MMF Holdings 3.4.2.1 FICC Repo Balances and MMF Holdings measure of overnight Treasury repo rates, Billions of US$ As Of: Sep-2020 Billions of US$ furthering the importance of this market. 800 300
Overnight Treasury FICC 700 250 DVP Repo (left axis) Repo borrowing, as reported in the Financial Accounts of the United States, totaled nearly 600 200 $4.1 trillion as of the second quarter of 2020, 500 150 down from $4.3 trillion a year earlier. The market consists of two segments: tri-party repo, 400 100 Money Market Fund FICC Repo Holdings (right axis) in which settlement occurs within the custodial 300 50 accounts of a clearing bank, and bilateral repo, which typically refers to all activity not settled 200 0 Apr:2018 Oct:2018 Apr:2019 Oct:2019 Apr:2020 within the tri-party system, includes repo Source: FRBNY, SEC Form Note: FICC cleared bilateral excludes term transactions cleared through the Fixed Income N-MFP, Bloomberg L.P. repo and repo backed by agency collateral. Clearing Corporation (FICC). Primary dealers, which are trading counterparties of FRBNY, are active in both segments of the market. Tri-party collateral balances declined 9.2 percent from a 3.4.2.2 Primary Dealer Repo Agreements 3.4.2.2 Primary Dealer Repo Agreements year earlier to $2.2 trillion in September 2020. Trillions of US$ As Of: 30-Sep-2020 Trillions of US$ Most of the decline occurred in the second 5 5 Overnight/Continuing quarter of 2020. Term 4 4 Recently, cleared bilateral repo transaction
3 3 volume has become comparable to, if not larger than, the tri-party volume. This is partly due 2 2 to the growth of sponsored repo, which allows sponsoring members to minimize balance 1 1 sheet usage by netting their repo lending and borrowing. Sponsored repo allows MMFs as 0 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 cash lenders, on one side of the transaction, Note: Aggregation method removes missing data when Source: FRBNY, occurs due to disclosure edits or non-trading days for and repo borrowers, on the other side, to Haver Analytics specific security repo agreements. participate in the FICC-cleared segment, but it also increases overall market exposure to FICC as a central counterparty (Chart 3.4.2.1).
3.4.2.3 Overnight Repo Volumes and Dealer Inventories Primary dealer cash borrowing in the repo 3.4.2.3 Overnight Repo Volumes and Dealer Inventories Billions of US$ As Of: 30-Sep-2020 Billions of US$ market, including borrowing from FRBNY’s 500 1500 temporary open market operations, stood at Primary Dealer Treasury Inventories (left axis) $2.5 trillion as of September 30, 2020, relatively 400 Overnight Treasury Repo 1300 flat compared to a year earlier but down from Volume (right axis) a peak of $3.0 trillion in the third week of 300 1100 March (Chart 3.4.2.2). Increased overnight
200 900 cash borrowing through the first quarter can be attributed to, among other things, 100 700 primary dealers’ elevated financing of Treasury inventories (Chart 3.4.2.3). The total repo 0 500 volumes reference all tenors and collateral 2016 2017 2018 2019 2020 types. Source: FRBNY, Staff Note: Overnight Treasury repo volume Calculations, Haver Analytics includes published volumes for SOFR.
38 2020 FSOC // Annual Report Similarly, cash lending by primary dealers 3.4.2.4 Primary Dealer Reverse Repo Agreements in the repo market (reverse repo) decreased 3.4.2.4 Primary Dealer Reverse Repo Agreements slightly over the past year, from $2.0 trillion Trillions of US$ As Of: 30-Sep-2020 Trillions of US$ 4 4 on September 26, 2019 to $1.9 trillion on Overnight/Continuing September 30, 2020, after reaching $2.3 trillion Term on March 18, 2020. The share of overnight 3 3 reverse repo compared to term reverse repo has increased over the past several years, accounting 2 2 for 50 percent of repo lending in September
2020, up from 39 percent in September 2016 1 1 (Chart 3.4.2.4). Lending at maturities of one month or longer continues to account for 0 0 approximately two-thirds of term reverse repo 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 lending. Source: FRBNY, Haver Analytics
As of September 2020, 93 percent of primary dealer repo transactions were collateralized by Treasuries or agency MBS, up from 92 percent 3.4.2.5 Primary Dealer Repo Collateral in September 2019 and 86 percent five years 3.4.2.5 Primary Dealer Repo Collateral prior (Chart 3.4.2.5). Within the tri-party Trillions of US$ As Of: 30-Sep-2020 Trillions of US$ market, 82 percent of repo transactions were 3.5 3.5 Agency Debt Other backed by Treasuries or agency MBS as of 3.0 Agency MBS Equities 3.0 U.S. Treasuries Corporates September 2020 compared to 83 percent in 2.5 2.5 September 2019 and 71 percent in September 2.0 2.0 2015 (Chart 3.4.2.6). Median haircuts on collateral used in tri-party repo transactions 1.5 1.5 were relatively flat for the year across most 1.0 1.0 collateral classes. 0.5 0.5
0.0 0.0 2014 2015 2016 2017 2018 2019 2020 Source: FRBNY, Haver Analytics Note: U.S. Treasuries includes TIPS.
3.4.2.6 Collateral in the Tri-Party Repo Market 3.4.2.6 Collateral in the Tri-Party Repo Market Trillions of US$ As Of: Sep-2020 Trillions of US$ 3.0 3.0 Other Agency Securities Other 2.5 Agency MBS Equities 2.5 U.S. Treasuries Corporates 2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Note: Other includes ABS, CDOs, private label Source: FRBNY, CMOs, international securities, money markets, Haver Analytics municipal debt, and whole loans.
Financial Developments 39 The repo market has experienced two recent 3.4.2.7 Repo Rate Spreads 3.4.2.7 Repo Rate Spreads periods of unexpected major volatility. The Percent As Of: 30-Sep-2020 Percent first was when overnight repo rates spiked in 4 4 3 Month GCF Repo – 3 Month OIS mid-September 2019, with SOFR increasing by Overnight SOFR – Overnight EFFR approximately 300 basis points (Chart 3.4.2.7). 3 3 Overnight GCF – Overnight EFFR The unexpectedly high volatility in September 2019 appeared to be attributed to technical 2 2 factors, including an increase in demand for funds (for example, to finance new Treasury 1 1 settlements), and a decline in funds available
0 0 from banks and MMFs that was tied to outflows as corporations paid taxes in mid-September.
-1 -1 While the spillover to the fed funds market was Jun:2018 Dec:2018 Jun:2019 Dec:2019 Jun:2020 relatively modest, repo market pressure pushed Source: FRBNY, Bloomberg, L. P. the effective federal funds rate slightly above the Federal Reserve’s target range.
Certain dealers may adjust their activity at quarter ends to meet regulatory requirements, a practice referred to as window-dressing, which can result in temporary increases in repo rates and may have contributed to repo market stress. Balance sheet constraints may also factor into repo rate increases observed on some Treasury settlement and tax dates, but these periodic increases have been small compared to the September 2019 spike.
In accordance with the FOMC’s directive, on September 17, 2019, FRBNY began to conduct a series of overnight and term repo operations to help maintain the federal funds rate within the target range by adding reserves to the banking system. The operations were effective in stabilizing conditions in funding markets. Additionally, the Federal Reserve commenced reserve management purchases of Treasury bills in October 2019, at the pace of $60 billion per month, in order to rebuild reserves to a level that is commensurate with policy implementation.
The repo market was strained again because of the market dislocations caused by the COVID-19 pandemic, with SOFR increasing by 29 basis points above the effective federal funds rate on March 17. Overnight and term repo rates against Treasury collateral spiked and term repo market functioning deteriorated
40 2020 FSOC // Annual Report amid increased dealer holdings and short-term 3.4.2.8 Value of Securities on Loan policy uncertainty. Investors also began selling 3.4.2.8 Value of Securities on Loan less-liquid securities to raise cash. To address Trillions of US$ As Of: 30-Sep-2020 Trillions of US$ this strain in the market, the Federal Reserve 3.0 3.0 stepped in again to purchase Treasury securities 2.5 2.5 – initially at a pace of $75 billion per day. The Global Market (including U.S.) Federal Reserve also increased available tenors 2.0 2.0 and offering amounts of its repo operations, which increased the supply of bank reserves 1.5 1.5 U.S. Market and countered some of the pressure in repo rates. Federal Reserve purchases of Treasury 1.0 1.0 securities reduced the supply of Treasuries in 0.5 0.5 the market and alleviated dealer balance sheet 2015 2016 2017 2018 2019 2020 pressure so dealers could better intermediate Note: Data is based on a across all asset classes and between the cash Source: Markit survey of agent-based lenders. and repo markets. Repo rates have been well contained since March.
Securities Lending Securities lenders generally engage in securities lending to earn additional income, but securities lending may also be used as a source of funding by some financial institutions. It is an unstable source of funding, however, as most arrangements allow the borrower to return the borrowed securities on short notice in exchange for the collateral posted. Data on the securities lending market are estimated based on surveys.
The estimated value of securities on loan globally was $2.5 trillion as of the end of September, 2020, up from $2.4 trillion in the end of September 2019 but down from $2.6 trillion in early March (Chart 3.4.2.8). The estimated U.S. share of the global activity grew to 57 percent at the end of September 2020 from 55 percent a year earlier.
Government bonds and equities continue to account for the majority of the estimated securities on loan globally. As of September 30, 2020, the share represented by equities was estimated at 40 percent, while government securities were estimated to account for approximately 47 percent of the total securities on loan.
While shares of ETFs were estimated to only account for 3.1 percent of securities on loan
Financial Developments 41 globally, the amount of shares of ETFs on loan 3.4.2.9 U.S. Securities Lending Cash Reinvestment 3.4.2.9 U.S. Securities Lending Cash Reinvestment has increased by approximately 40 percent Trillions of US$ As Of: 2020 Q3 Days for the twelve months ended September 30, 2.4 300 2020. One potential reason for this increase in Total Cash Reinvestment 2.0 (left axis) 250 demand could be that ETFs are an efficient way for hedge funds to gain short exposure. As with 1.6 200 the trend for securities lending overall, however, Mean WAM (right axis) 1.2 150 the estimate of the value of ETF shares on loan Median WAM (right axis) decreased after peaking in early March. 0.8 100
0.4 50 Reinvestment of cash collateral from securities lending in the U.S. was estimated 0.0 0 2006 2008 2010 2012 2014 2016 2018 2020 at approximately $600 billion as of the third Source: The Risk Note: Data is based on a quarter of 2020, down $20 billion from the Management Association survey of agent-based lenders. previous year (Chart 3.4.2.9). A growing number of the cash reinvestment managers surveyed have shortened portfolio duration amid market uncertainty. The median weighted average 3.4.2.10 U.S. Securities Lending Cash Reinvestment Collateral 3.4.2.10 U.S. Securities Lending Cash Reinvestment Collateral maturity (WAM) of cash reinvestment portfolios Percent of Total As Of: 2020 Q3 Percent of Total decreased to 54 days in the third quarter of 2020 100 100 compared to 67 days in the third quarter of 2019, Other Commercial Paper while the mean WAM dropped from 86 days to 80 80 Bank Deposits 63 days over the same period. 60 Money Market Funds 60 Government Repo As noted in Box D, cash collateral is often 40 40 Corporate Securities invested in the short-term funding markets 20 20 (STFMs). The estimated share of cash Nongovernment Repo reinvestment portfolios allocated to repos 0 0 backed by non-government collateral recorded 2012 2014 2016 2018 2020 a decline during the first quarter of 2020 from Note: Nongovernment repos have collateral of whole Source: The Risk Management loans, equity, and corporate debt. Other includes ABS, funding agreements, other funds, and other vehicles. 28 percent to 17 percent, before increasing to 27 Association, OFR Data is based on a survey of agent-based lenders. percent during the third quarter of 2020. The share of bank deposit and government repo rose to 18 percent and 13 percent respectively before declining to 16 percent and 11 percent in the third quarter. The share of CP used as collateral in repo transactions declined to 5.8 percent in the first quarter, before increasing to 9.2 percent in the third quarter (Chart 3.4.2.10).
42 2020 FSOC // Annual Report Box D: Recent Stress in Short-Term Wholesale Funding Markets
STFMs are the $10 trillion network of markets the discount rate by 150 basis points and was and entities that help provide short-term credit for successful in encouraging and destigmatizing the use corporations, governments, and financial institutions. of its discount window. These include secured borrowing markets such as those for repos and securities lending, as well Money Market Mutual Funds as unsecured borrowing markets such as bank Market conditions for unsecured short-term debt deposits and CP. Since some of the intermediaries instruments, such as CP and negotiable certificates that participate in the federal funds market also of deposit (NCDs), began to deteriorate rapidly in participate in other STFMs, well-functioning STFMs the second week of March. Spreads for money are critical not only for financial stability but also for market instruments began widening sharply, and the implementation of monetary policy. new issuance of CP and NCDs declined markedly Amid escalating concerns about the economic and shifted to short tenors. Stress among MMFs impact of the COVID-19 pandemic, market likely contributed to these problems, as prime funds participants rapidly reduced their tolerance for risk reduced their holdings of CP disproportionately and generally shifted their risk preferences toward compared to other holders. At the end of February cash and other highly liquid instruments. This rapid 2020, prime MMFs offered to the public owned shift in investor sentiment placed stress on both the approximately $215 billion of CP, or about 19 percent secured and unsecured components of STFMs and of the $1.1 trillion outstanding CP at that time. From the intermediaries operating in these markets. March 10 to March 24, these funds cut holdings of CP by $35 billion, and this reduction accounted Unsecured Funding for 74 percent of the $48 billion overall decline in outstanding CP over those two weeks. Bank Funding Conditions in the short-term municipal debt markets With sources of market liquidity drying up, businesses also worsened rapidly in mid-March. On March drew heavily on bank lines of credit. Several factors 18, the Securities Industry and Financial Markets have helped banks meet this surge in liquidity Association (SIFMA) Municipal Swap Index yield—a demand. First, post-crisis regulation has required that benchmark rate in these markets—rose to 520 basis banks maintain strong capital and liquidity positions points, a 392 basis point increase from the prior while reducing their reliance on short-term wholesale week. The spike in the SIFMA index yield caused funding. Second, deposit inflows surged because drops in market-based net asset values (NAVs) of tax- businesses deposited their precautionary credit-line exempt MMFs (which mostly still have stable, rounded withdrawals, businesses and consumers deposited NAVs) and likely contributed to outflows from these government stimulus payments, and investors moved funds. Stress among tax-exempt MMFs also likely away from risky illiquid assets into cash. Third, contributed to worsening market conditions. A period some banks increased discount window borrowing of unusually heavy redemptions from tax-exempt and Federal Home Loan Bank (FHLB) advances to MMFs began on March 12, and outflows accelerated manage the surge in liquidity demand. The FHLBs over the next week. Tax-exempt funds reduced their generally expanded eligible categories of collateral to holdings of variable-rate demand notes (VRDNs) by reflect the new funding programs and facilities of the about 16 percent ($15 billion) in the two weeks from SBA and Federal Reserve, reduced rates, extended March 9 to 23. Primary dealer VRDN inventories grants to members, and waived fees for certain nearly tripled in the week ending March 18. Stress in products. For its part, the Federal Reserve lowered
Box D: Recent Stress in Short-Term Wholesale Funding Markets 43 Box D: Recent Stress in Short-Term Wholesale Funding Markets
municipal markets also contributed to strains on tax- the launch of the MMLF. The share of CP issuance exempt MMFs. with overnight maturity began falling on March 24, and As part of the general deterioration in STFM spreads to OIS for most types of term CP began falling conditions, prime and tax-exempt MMFs experienced a few days later. After the expansion of the MMLF to heavy redemptions beginning in the second week include municipal securities on March 20 (and VRDNs of March 2020. Outflows increased quickly, peaking on March 23), tax-exempt MMF outflows eased and on March 17 for prime funds (the day the Federal conditions in the short-term muni markets improved. Reserve announced the CPFF) and on March 23 for While stress affected a variety of money-market tax-exempt funds (one business day after the MMLF instruments and investment vehicles, the availability of was expanded to include tax-exempt securities). secondary-market liquidity for MMFs’ assets via the MMLF appears to have had a broad calming effect on Among institutional prime MMFs offered to the public, STFMs. For example, although assets of other funds, outflows as a percentage of fund assets exceeded including European dollar-denominated MMFs, could not those in the September 2008 crisis. Over the two- be financed through MMLF loans, outflows from these week period from March 11 to 24, net redemptions funds abated shortly after the MMLF began operations from publicly offered institutional prime funds totaled on March 23. 30 percent (about $100 billion) of the funds’ assets. For comparison, in September 2008, the worst Secured Funding outflows from these funds over a two-week period were about 26 percent (about $350 billion) of assets. Repurchase Agreements For retail prime funds, outflows as a share of assets The market for repos consists of many different in March 2020 exceeded those that occurred during participants that provide or demand secured short- the 2008 crisis, although heavy redemptions began a term funding against securities (typically Treasury and couple of days after those for institutional funds. Net agency MBS) posted as collateral. It is a critical source redemptions totaled 9 percent (just over $40 billion) of liquidity for a variety of market participants, many of of assets over the two weeks from March 13 to 26. whom depend predominantly on this market for their In September 2008, the heaviest retail outflows over funding. a two-week period totaled 5 percent of assets. Retail Broker-dealers, many of whom are subsidiaries of large prime funds had about 60 percent more assets in BHCs, play a key role in the U.S. repo market as they 2008 than earlier this year, so outflows were similar in intermediate funds between ultimate cash lenders, dollar terms in both crises. such as MMFs, and ultimate cash borrowers (such Outflows from tax-exempt MMFs, which are largely as hedge funds). Other market participants include retail funds, were 8 percent ($11 billion) of assets asset managers, such as mutual funds and ETFs, who during the two weeks from March 12 to 25. In 2008, borrow from as well as lend to the repo market. Certain when tax-exempt MMF assets were more than four leveraged participants, such as hedge funds and times larger than earlier this year, such funds had mortgage REITs, typically fund themselves using short- outflows of 7 percent (almost $40 billion) of assets in term repo funding. one two-week period. With economic prospects declining at the onset of the Outflows from MMFs abated fairly quickly after the pandemic, many investors and market participants Federal Reserve’s announcement of its support increased their demand for liquidity. Investors sought to for the STFMs, including support for MMFs in mid- sell traditionally liquid securities with minimal credit risk, March. Market conditions began to improve after such as Treasuries and agency MBS, to obtain cash. In
44 2020 FSOC // Annual Report the case of Treasuries, there had been significant in both markets. While MMFs cannot participate in the selling pressure from foreign investors and foreign federal funds market, some MMFs invest in closely related central banks (see Box B). As noted in Section certificates of deposit issued outside the U.S., known as 5.5, these selling pressures likely stressed balance Eurodollar instruments. Similarly, securities dealers are sheets of the securities dealers that intermediate in major participants in the secured (repo) market. Given the repo market. these interconnections, stress in one market can be readily transmitted to another and more generally, to the Securities Lending broader financial markets. Securities lending supports the orderly operation of capital markets, principally by enabling the establishment of short positions and thereby facilitating price discovery and hedging. This lending typically is secured by cash or other securities. As noted in Section 3.5.2, it is estimated that at the end of September 2020 the global securities lending volume outstanding was $2.5 trillion, with around 57 percent of it attributed to the U.S. The key interconnection between this market and the broader financial system stems from the fact that a large portion of cash collateral is reinvested in the STFMs. The fall in asset prices in March 2020 led to deleveraging by market participants that typically borrow securities, and the lower asset prices and lower demand for new securities lending in general reduced the amount of cash collateral reinvested in the STFMs. This deleveraging limited the supply of capital available in the STFMs, making it more difficult for issuers in the real economy to access capital.
Interconnection of STFMs and Other Financial Markets The STFMs are a complex ecosystem that involve significant daily flows through a network of highly interconnected market segments and the economy more generally. Depository institutions can participate in the secured (repo) and the unsecured (federal funds) market. For example, depository institutions have participated as cash lenders in the repo market when the repo rates exceeded the interest on excess reserves. In addition, other market participants, such as the FHLBs, also participate
Box D: Recent Stress in Short-Term Wholesale Funding Markets 45 3.4.3.1 U.S. Futures Markets: Volume 3.4.3 Derivatives Markets 3.4.3.1 U.S. Futures Markets Volume 3.4.3.1 Futures Billions of Contracts As Of: Jul-2020 Billions of Contracts U.S. futures markets generally performed 6 6 well through the March and April COVID-19 5 5 market stress, providing price formation, price discovery, and risk management functions 4 4 for market participants during a period of 3 3 increased uncertainty. Commercial participants
2 2 such as farmers, ranchers, producers, service providers, and intermediaries as well as non- 1 1 commercial participants such as asset managers,
0 0 hedge funds, market makers, and various retail 2015 2016 2017 2018 2019 2020 (Jan- Jul) and other investors contributed to record levels Source: CFTC Note: 2020 volume annualized. of activity across multiple futures markets. During the first seven months of 2020, volume levels across U.S. futures exchanges rose by over 15 percent on an annualized basis compared to 2019, due to higher volatility, an increase of 3.4.3.2 3-Month Implied Volatility 3.4.3.2 3-Month Implied Volatility short-term trading activities, and significant Percent As Of: 30-Sep-2020 Percent hedging and investment needs (Chart 3.4.3.1). 150 150 The pandemic’s impact on the U.S. futures 120 Crude Oil 120 S&P 500 markets was most significant during March and Corn April when various fundamental and market 90 Gold 90 risk factors drove implied volatility to extreme
60 60 levels (Chart 3.4.3.2). At the same time, futures liquidity, as represented by top-of-book depth, 30 30 declined and the steep drop in asset prices drove volumes higher, while the notional 0 0 amount of open interest decreased (Chart Sep:2019 Dec:2019 Mar:2020 Jun:2020 Sep:2020 3.4.3.3). The pace of the global news flow and Source: Bloomberg, L.P., CFTC the accompanying sell-offs triggered limit down in various asset classes. For example, e-mini S&P 500 futures hit the 5 percent limit down band in five overnight sessions in March and hit 3.4.3.3 U.S. Futures Markets Open Interest the 5 percent limit up band in another three 3.4.3.3 U.S. Futures Markets Open Interest Trillions of US$ As Of: Jun-2020 Trillions of US$ overnight sessions. 35 35
30 30 Exchanges took various emergency actions to address operational concerns and enable 25 25 efficient price discovery and price transparency. 20 20 The CFTC also issued no-action letters 15 15 providing temporary, targeted relief to futures
10 10 commission merchants (FCMs), introducing brokers, floor brokers, certain designated 5 5 contract markets, and other market participants 0 0 2015 2016 2017 2018 2019 2020 to help facilitate orderly trading and liquidity
Note: Futures contracts are dollarized using prices while market participants operated away from Source: CFTC from contract definitions and other relevant data. their normal business sites.
46 2020 FSOC // Annual Report Over the past year, open interest in “micro” 3.4.3.4 Micro Futures: Open Interest futures contracts has increased significantly, 3.4.3.4 Micro Futures Open Interest totaling $3 billion as of June 2020 (Chart Billions of US$ As Of: Jun-2020 Billions of US$ 4 4 3.4.3.4). Micro contracts are designed to Energy make futures trading more accessible to retail Stock Indices Metals 3 3 investors and are typically one-tenth of the size Currencies of benchmark futures contracts. Micro equity futures, which were first introduced in May 2 2 2019, have driven much of the recent growth in micro contracts. Micro metals contracts have 1 1 also driven the recent growth, and open interest in micro metals has more than quadrupled 0 0 since 2018. Despite this growth, micro futures 2015 2016 2017 2018 2019 2020 account for a small share of open interest. For Note: Futures contracts are dollarized using prices Source: CFTC from contract definitions and other relevant data. example, the notional amount outstanding for the micro e-mini S&P 500 index is less than 1 percent of that for the benchmark e-mini futures contract. 3.4.3.5 U.S. Treasury Futures: Open Interest 3.4.3.5 U.S Treasury Futures Open Interest As discussed in Box B, open interest in U.S. Billions of US$ As Of: 29-Sep-2020 Billions of US$ 900 900 Treasury futures indicated a significant shift in Asset 5Y 30Y Managers 2Y 10Y positioning by asset managers and leveraged 600 600 funds (Chart 3.4.3.5). The asset managers, which include pension and other long-only 300 300 unleveraged funds, are long futures across 0 0 the Treasury curve, while leveraged funds are -300 -300 short futures across the curve. In 2018 and the first half of 2019, leveraged funds and -600 -600 Leveraged 5Y 30Y asset managers significantly increased their Funds 2Y 10Y -900 -900 net exposures in Treasury futures, peaking Jan:2016 Jan:2017 Jan:2018 Jan:2019 Jan:2020 Note: Net notional amount of open interest by trader type. 10Y at around $600 billion in the third quarter includes 10Y and 10Y Ultra Treasury Note Futures; 30Y of 2019. Since the pandemic and given the Source: CFTC includes Treasury Bond and Ultra Treasury Bond Futures. current interest rate environment and outlook, the aggregate level of open interest across all Treasury futures contracts has nearly halved. This reduction in net positions has primarily been in the 2-year and 10-year Treasury futures.
3.4.3.2 Options Equity Options In early 2020, the COVID-19 pandemic impacted the operations of the five equity options exchanges that maintain a physical trading floor, causing each of them to transition to fully-electronic trading as social distancing restrictions came into effect. Trading returned to the physical floors as they began to reopen at the end of the second quarter of 2020, but floor volumes remain below pre-pandemic
Financial Developments 47 levels. At the same time, overall options volume 3.4.3.6 Exchange-Traded Equity Option Volume 3.4.3.6 Exchange-Traded Equity Option Volume has dramatically increased, with average daily Millions of Contracts As Of: Sep-2020 Millions of Contracts volumes for exchange-traded equity options 25 25 reaching a record 20 million contracts in Put Options Call Options September 2020 (Chart 3.4.3.6). 20 20
15 15 The recent growth of option volumes has been concentrated in call options on technology 10 10 stocks. For example, the average daily volume for call options on six large technology stocks 5 5 has roughly tripled over the past year, peaking at over 6 million contracts in August (Chart 0 0 Jan:2019 Jul:2019 Jan:2020 Jul:2020 3.4.3.7). Some reports indicate that the Note: Average daily volume. Excludes index increase in volume has been driven, in part, Source: The OCC and ETF options. by an increase in retail investor participation as broker-dealers have enhanced their options trading offerings and have lowered or eliminated their trading commissions. 3.4.3.7 Call Option Volume for Select Technology Stocks 3.4.3.7 Call Option Volume for Select Technology Stocks Millions of Contracts As Of: 30-Sep-2020 Millions of Contracts Exchange-Traded Options on Futures 14 14 Over the past five years, open interest for U.S.
12 Daily Volume 12 exchange-traded options on futures averaged 20-Day Moving Average approximately $40 trillion on a non-delta 10 10 adjusted basis. Notional exposures to options 8 8 on futures are concentrated in the highly liquid
6 6 benchmark CME 3-month Eurodollar interest rate contract. Excluding Eurodollars, open 4 4 interest for options on futures contracts stood 2 2 at approximately $2.2 trillion in non-delta 0 0 adjusted notional value in 2019 (Chart 3.4.3.8). 2016 2017 2018 2019 2020 Note: Includes daily call option volume for TSLA, Source: Bloomberg, L.P. AAPL, NFLX, GOOG, FB, and MSFT.
3.4.3.8 Options on Futures: Open Interest 3.4.3.8 Options on Futures: Open Interest Trillions of US$ As Of: Jun-2020 Trillions of US$ 3.0 3.0 Agriculture Energy 2.5 Stock Indices Currencies 2.5 Treasury Futures Metals Thousands Thousands 2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0 2015 2016 2017 2018 2019 2020
Source: CFTC Note: Excludes Eurodollar futures on options.
48 2020 FSOC // Annual Report Option volumes across all markets increased 3.4.3.9 Options on Futures: Volume between 2014 and 2019; over one billion option 3.4.3.9 Options on Futures: Volume contracts traded in 2019 (Chart 3.4.3.9). Over Millions of Contracts As Of: Jun-2020 Millions of Contracts 1250 1250 the past five years, Eurodollar options volume Other Options Eurodollar Options has accounted for approximately 35 percent of all 1000 1000 volume on exchange-traded options on futures. 750 750 Between 2015 and 2019, the delta-adjusted notional amount of options on futures nearly 500 500 tripled, from $6.9 trillion in June 2015 to $18 trillion in June 2019 (Chart 3.4.3.10). Much of 250 250 this growth could be attributed to increased 0 0 open interest in Eurodollar options contracts. 2015 2016 2017 2018 2019 2020 Open interest for options on futures fell to $13 Source: CFTC trillion in June 2020 as interest in Eurodollar contracts declined given the reduced uncertainty in the outlook for short-term interest rates. 3.4.3.10 Options on Futures: Delta Adjusted Open Interest 3.4.3.10 Options on Futures: Delta Adjusted Open Interest Excluding Eurodollar instruments, options Trillions of US$ As Of: Jun-2020 Trillions of US$ referencing financial futures account for 20 20 approximately 58 percent of outstanding, with options on equity indices, Treasury futures, 15 15 and currencies accounting for 31 percent, 23 percent, and 4.3 percent of delta-adjusted open 10 10 interest, respectively (Chart 3.4.3.11). Within the commodity space, options on metals, 5 5 energy, and agriculture futures account for 22 percent, 12 percent, and 8 percent of delta- 0 0 adjusted open-interest, respectively. 2015 2016 2017 2018 2019 2020 Note: Delta adjusted open interest as of June 30 of Options on Treasury futures are considered to Source: CFTC each year. Includes Eurodollar futures on options. be among the most liquid options on futures contracts, with significant activity in low-delta, or deep-out-of-the-money options. Low-delta options (less than 0.2) have strike prices far 3.4.3.11 Delta Adjusted Options on Futures by Asset Classes 3.4.3.11 Delta Adjusted Options on Futures by Asset Class away from prevailing futures prices and provide As Of: Jul-2020 protection against tail-risk events. Consequently, $0.7B trading and open interest in low delta options tend to pick up during periods of increased $81.3B Other Stock Index uncertainty or volatility in the rates market. $115.7B Energy The ratio of puts to calls is a good indicator of Treasuries the overall bias of the marketplace. Higher puts $29.7B Currencies relative to calls may indicate increased hedges Agriculture Metals against rising rates (in yield terms) and lower $44.4B $16.3B puts relative to calls may indicate a bias towards $83.9B falling rates. After the put-call ratio on 10-year Treasury futures spiked in March 2020, those Note: Delta adjusted open interest. Source: CFTC Excludes Eurodollar options.
Financial Developments 49 ratios declined to more normal levels (Chart 3.4.3.12 Options on 10-Year Treasury Futures 3.4.3.12 Options on 10-Year Treasury Futures 3.4.3.12). Millions of Contracts As Of: 28-Jul-2020 Ratio 5 9 OTC Options Tail Risk Puts (left axis) 8 According to the Bank for International Tail Risk Calls (left axis) 4 7 Put / Call Ratio (right axis) Settlements (BIS), the global gross notional 6 amount outstanding of over-the-counter (OTC) 3 5 options remained relatively steady at around $56 4 2 trillion as of December 2019. Interest rate option 3 contracts represent the bulk of that figure, 1 2 ending 2019 at just under $40 trillion in notional 1 outstanding, which is down slightly from 2018. 0 0 The notional amount of OTC equity options as 2016 2017 2018 2019 2020 of the fourth quarter of 2019 was approximately Source: CFTC $3.7 trillion, remaining below the peak of $8.5 trillion in the second quarter of 2008.
At the end of the second quarter of 2020, BHCs 3.4.3.13 OTC Options: BHC Gross Notional Outstanding 3.4.3.13 OTC Options: BHC Gross Notional Outstanding held $39 trillion in OTC options, a decline from Trillions of US$ As Of: 2020 Q2 Percent earlier years (Chart 3.4.3.13). This decrease 60 100 is primarily attributable to a reduction in Other (left axis) Percent Held by 6 Largest Equity (left axis) BHCs by Total Assets (right 99 exposures at certain large BHCs. As a result, the 50 Foreign Exchange (left axis) axis) Interest Rate (left axis) share of option exposures attributed to the six 98 40 largest BHCs fell from 98 percent in the fourth 97 quarter of 2018 to 95 percent in the second 30 96 quarter of 2020. Over the same period, BHC net 20 95 notional exposures to options—as measured by written minus purchased options—fell from 10 94 $3.2 trillion to $2.5 trillion, though they are 0 93 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 still well above levels observed between 2011 Source: FR Y-9C, Staff Note: Other includes credit, and 2016 (Chart 3.4.3.14). Calculations commodity, and other OTC options. 3.4.3.3 OTC Derivatives Activity in the OTC derivatives market increased sharply during the March 2020 3.4.3.14 OTC Options: BHC Net Notional Outstanding market stress. In March 2020, interest rate 3.4.3.14 OTC Options: BHC Net Notional Outstanding swap trading volumes hit record levels, with Trillions of US$ As Of: 2020 Q2 Trillions of US$ 4 4 weekly volumes peaking at over $20 trillion Other for the week ending March 6, 2020. Volumes Equity 3 Foreign Exchange 3 in CDS markets roughly doubled from the Interest Rate previous year but remained below their peak 2 2 weekly volume in 2016. The increase in trading volumes is largely related to market participants 1 1 repositioning portfolios in response to central
0 0 bank interest rate cuts and increased economic uncertainty. Additionally, some reports suggest -1 -1 that institutional investors relied on CDS 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 markets due to the rapid deterioration of Source: FR Y-9C, Staff Note: Other includes credit, Calculations commodity, and other OTC options. liquidity conditions in the underlying corporate
50 2020 FSOC // Annual Report bond markets. OTC activity has since decreased 3.4.3.15 Derivatives Notional Volume to pre-pandemic levels (Chart 3.4.3.15). 3.4.3.15 Derivatives Notional Volume Trillions of US$ As Of: 25-Sep-2020 Trillions of US$ 1.0 15 Concurrently, the notional amount of OTC Credit Default Swaps (left axis) Interest Rate Swaps derivatives outstanding rose during the 0.8 (right axis) 12 COVID-19 market stress but have since returned to pre-pandemic levels (Chart 3.4.3.16). The 0.6 9 notional amount of index CDS outstanding peaked at $5.7 trillion in the last week of March, 0.4 6 a nearly 50 percent increase from year-end 0.2 3 2019; interest rate swaps outstanding peaked at over $300 trillion in the first week of March, a 0.0 0 20 percent increase from year-end 2019. By the 2015 2016 2017 2018 2019 2020 end of September 2020, the notional amount of Note: 12-week moving-averages. Source: CFTC Excludes security-based swaps. index CDS and interest rate derivatives declined to $4.4 trillion and $250 trillion, respectively.
As discussed in Box A of the Council’s 2018 3.4.3.16 Derivatives Notional Amount Outstanding annual report, the size of the interest rate 3.4.3.16 Derivatives Notional Amount Outstanding swaps market can also be expressed on an Trillions of US$ As Of: 25-Sep-2020 Trillions of US$ entity-netted notional (ENN) basis, which 12 500 10 attempts to risk-adjust notional amounts by (1) 400 expressing the notional amount of each swap Interest Rate Swaps 8 (right axis) in 5-year equivalents; and (2) netting offsetting 300 positions for every pair of counterparties. While 6 200 the notional amount of interest rate swaps has 4 Credit Default Swaps (left axis) decreased to pre-pandemic levels, risk-adjusted 100 2 ENN exposures remain elevated, indicating the increased market risk transfer in the interest 0 0 2014 2015 2016 2017 2018 2019 2020 rate swaps markets (Chart 3.4.3.17). Note: Weekly Swaps Report not issued between Dec. 22, 2018 and Jan. 26, 2019 due to a lapse in government Source: CFTC funding. Excludes security-based swaps.
3.4.3.17 Size of Interest Rate Swap Market 3.4.3.17 Size of Interest Rate Swap Market Trillions of US$ As Of: 2020 Q2 Trillions of US$ 280 18
260 Notional Amounts 17 (left axis)
240 16
220 15
200 Entity-Netted Notional 14 (right axis)
180 13 Mar:2018 Sep:2018 Mar:2019 Sep:2019 Mar:2020
Note: Total notional amount and entity-netted notional Source: CFTC Office of amount as reported in “Introducing ENNs: A Measure Chief Economist of the Size of Interest Rate Swap Markets.”
Financial Developments 51 3.4.3.18 Global OTC Positions The notional amount of global OTC derivative 3.4.3.18 Global OTC Positions positions totaled $607 trillion as of June 2020, Trillions of US$ As Of: 2020 Q2 Trillions of US$ a 5.2 percent decrease compared to June 2019 1,000 40 Notional Amounts (Chart 3.4.3.18). This decline was largely driven (left axis) by a decline in the amount of outstanding OTC 800 Gross Market Values (right axis) 30 interest rate and FX derivatives contracts, which Gross Credit Exposures fell by $29 trillion and $4.8 trillion respectively. 600 (right axis) 20 In contrast, the gross market value of 400 outstanding OTC derivatives, which provides a measure of amounts at risk, rose to $15 trillion 10 200 as of June 2020, a $3.4 trillion increase over the year. Interest rate derivatives saw the largest 0 0 increase in gross market value, as the decline 2000 2003 2006 2009 2012 2015 2018 in central bank policy rates lifted the market Source: BIS, Haver Analytics value of outstanding interest rate derivatives. Gross credit exposures, which adjust gross market values for legally enforceable bilateral netting agreements (but not for collateral), also 3.4.3.19 Commodity Index Swaps: Annual Open Interest 3.4.3.19 Commodity Index Swaps: Annual Open Interest increased, from $2.7 trillion as of June 2019 to Billions of US$ As Of: Jun-2020 Billions of US$ $3.2 trillion as of June 2020. 70 70
60 60 Commodity Index Swaps During the past five years, the use of commodity 50 50 index swaps has expanded significantly, with 40 40 approximately $62 billion outstanding in 2019 30 30 versus $27 billion in 2015 (Chart 3.4.3.19). The
20 20 overall exposure of commodity index swaps, however, declined during the pandemic months 10 10 as investors reduced exposures to commodities. 0 0 Commodity index swap exposures, which fell to 2015 2016 2017 2018 2019 2020 as low as $35 billion, have since rebounded to Source: CFTC Note: Notional exposure of commodity index swaps. $50 billion as of June 2020 (Chart 3.4.3.20).
3.4.3.20 Commodity Index Swaps: Monthly Open Interest 3.4.3.20 Commodity Index Swaps: Monthly Open Interest Billions of US$ As Of: Jul-2020 Billions of US$ 100 100
80 80
60 60
40 40
20 20
0 0 Aug:2019 Nov:2019 Feb:2020 May:2020 Note: Month-end notional exposure of Source: CFTC commodity index swaps.
52 2020 FSOC // Annual Report Similarly, the use of single commodity swaps 3.4.3.21 Commodity Swaps: Open Interest has increased significantly over the past five 3.4.3.21 Commodity Swaps: Open Interest years (Chart 3.4.3.21). This growth can be Billions of US$ As Of: Jun-2020 Billions of US$ 1500 1500 attributed largely to an increase in commercial- driven activity, particularly with customization 1250 1250 of commodity swaps. Energy-based swaps are 1000 1000 the most popular category of single commodity swaps, with natural gas- and crude oil-based 750 750 swaps accounting for 31 percent and 28 percent 500 500 of total single commodity swaps outstanding over the past five years, respectively (Chart 250 250 3.4.3.22). 0 0 2015 2016 2017 2018 2019 2020 3.4.3.4 Futures Commission Merchants Note: Average month-end notional Source: CFTC exposure across 25 key contracts. FCMs collect funds from customers to margin centrally cleared futures, options on futures, and swap transactions. In addition to managing the deposit and withdrawal of customer 3.4.3.22 Commodity Swaps by Asset Class margin funds with CCPs, FCMs guarantee the 3.4.3.22 Commodity Swaps by Asset Class performance of their customers to the CCP. As Of: Jul-2020
Concerning centrally cleared futures and $59B options on futures, the level of customer Other Softs $57B $189B margin funds held by FCMs remained fairly flat Oil Seeds Grains prior to the pandemic, but has since increased $56B Metals significantly Chart( 3.4.3.23). In March 2020, Other Energy Natural Gas $59B the amount of required client margin for U.S. Crude and foreign futures spiked to $318 billion, $43B a $104 billion increase from February 2020. $204B Similarly, the amount of required client margin for swaps increased by $33 billion to $153 Note: 5-year average notional contribution billion in March. Increased trading volumes, Source: CFTC of the major commodity categories. along with increases in CCP and FCM margin requirements, caused a sharp increase in required client margin. While market volatility has since subsided, the total amount of required 3.4.3.23 Margin Funds Held at CFTC Registered FCMs 3.4.3.23 Margin Funds Held at CFTC Registered FCMs client margin held by FCMs remained elevated Billions of US$ As Of: Sep-2020 Billions of US$ through the summer, totaling $439 billion in 500 500 Swaps September 2020. Foreign Futures 400 U.S. Futures 400 Over the last two decades, the number of 300 300 FCMs holding customer funds has declined considerably, with the number of FCMs clearing 200 200 futures for clients falling from over 100 in
2002 to 53 as of September 2020; 26 of these 100 100 are bank-affiliated. The number of FCMs that report holding segregated client funds for the 0 0 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 centrally cleared swaps business decreased from 23 at year-end 2014 to 16 (of which 14 Source: CFTC
Financial Developments 53 are bank-affiliated) as of September 2020. The 3.4.3.24 FCM Concentration: Customer Futures Balances 3.4.3.24 FCM Concentration: Customer Futures Balances pace of consolidation in the FCM industry has Percent As Of: 2020 Q3 Percent slowed since 2015, however, and the number of 100 100 FCMs clearing swaps and futures for customers Top 10 Top 5 Top 3 remained relatively consistent over the last 75 75 several years.
50 50 Between the first quarter of 2014 and the third quarter of 2020, the top five clearing members 25 25 at futures exchanges held between 48 and 60 percent of client margin for futures products, 0 0 and the top five swap clearing members held 2014 2015 2016 2017 2018 2019 2020 between 68 and 78 percent of client margin for Note: Represents total amount of funds that an FCM is required to segregate on behalf of customers who are swaps products (Charts 3.4.3.24, 3.4.3.25). Source: CFTC trading futures and options on futures at US exchanges. 3.4.3.5 Swap Dealers Swap dealers (SDs) began registering with the CFTC in December 2012; as of October 2020, 3.4.3.25 FCM Concentration: Customer Swap Balances 3.4.3.25 FCM Concentration: Customer Swap Balances there were 109 registered SDs, an increase from As Of: 2020 Q3 the 80 provisionally registered SDs at the end Percent Percent Top 10 Top 5 Top 3 100 100 of 2013. Between 2014 and 2018, registered SD activity remained concentrated, with the top three SDs accounting for over 30 percent of 75 75 swap positions and the top ten SDs accounting for over 55 percent of swap positions. Since 50 50 2018, the concentration of swap contracts with the largest SDs has declined slightly. As of the 25 25 third quarter of 2020, the share of contracts held by the top three SDs totaled 27 percent, 0 0 2014 2015 2016 2017 2018 2019 2020 while the share of contracts held by the top ten Note: Represents the amount of funds an FCM is required SDs totaled 50 percent (Chart 3.4.3.26). Source: CFTC to segregate for customers who trade cleared swaps. 3.4.3.6 Swap Execution Facilities Certain interest rate swaps and index CDS have been “made available to trade,” and therefore 3.4.3.26 Concentration of Swap Positions for Registered SDs are required to be executed on a Swap 3.4.3.26 Concentration of Swap Positions for Registered SDs Execution Facility (SEF), an exempt SEF, or a Percent As Of: 2020 Q3 Percent 70 70 designated contract market. Combined with 60 Top 10 Top 5 Top 3 60 mandatory central clearing, these regulated
50 50 trading platforms have increased pre-trade price transparency, reduced operational risk, 40 40 and improved end-to-end processing. 30 30
20 20 The level of U.S.-regulated swaps executed 10 10 on SEFs has continued to rise and SEF trade
0 0 volumes picked up considerably during the Q3 2014 Q3 2015 Q3 2016 Q3 2017 Q3 2018 Q3 2019 Q3 2020 COVID-19 market volatility. In March 2020, Note: Positions between two Swap Dealers (SDs) in the same the notional amount of interest rate swaps category (e.g., Top 3 or Top 5) are double-counted (i.e., a trade Source: CFTC between the #1 SD and #3 SD would be counted twice). traded on-SEFs averaged $689 trillion, down
54 2020 FSOC // Annual Report slightly from its January 2020 peak, but 13 3.4.3.27 Interest Rate Swap SEF Trading Volumes percent higher compared to March 2019 (Chart 3.4.3.27 Interest Rate Swap SEF Trading Volumes 3.4.3.27). Nonetheless, the share of interest Billions of US$ As Of: Sep-2020 Percent rate swaps trading that occurred on SEFs fell to 1250 80 On-SEF Interest Rate Share of Total Interest Rate below 50 percent in February and March 2020, Swap Volume (left axis) Swap Volume (right axis) 1000 70 as off-SEF trading hit record levels. The share of interest rate swaps traded on SEFs has since 750 60 rebounded to 62 percent in September 2020.
500 50 The average daily volume for index CDS SEF trading surged to $78 billion in March 2020, 250 40 well above the previous monthly record set in February 2018 and a 115 percent increase 0 30 Jan:17 Jan:18 Jan:19 Jan:20 from March 2019 (Chart 3.4.3.28). In recent Source: CFTC Note: Average daily notional volume. years, the share of index CDS swaps trading that occurred on SEFs has remained relatively stable at around 70 to 80 percent. During the COVID-19 market stress, the share of index 3.4.3.28 Credit Default Swap SEF Trading Volumes CDS trading that occurred on SEFs increased 3.4.3.28 Credit Default Swap SEF Trading Volumes slightly to 82 percent in March 2020. SEF Billions of US$ As Of: Sep-2020 Percent trading volumes have since declined, but the 100 100 On-SEF CDS Volume Share of Total CDS share of index CDS executed on SEFs has Volume (right axis) 80 (left axis) 90 remained elevated, totaling 81 percent in
September 2020. 60 80
3.4.4 Commodities Market 40 70 The U.S. commodity derivatives markets cover energy, agricultural, and metals industries 20 60 through various products, including futures, options, swaps (both single commodity and 0 50 Jan:17 Jan:18 Jan:19 Jan:20 commodity index), and a growing commodity Note: Average daily notional volume. ETF and exchange-traded notes (ETN) market. Source: CFTC Excludes security-based swaps. The U.S. commodity derivatives markets serve important price formation and price discovery functions, allowing both U.S. and global participants to hedge, invest, and manage risk. These markets also provide a basis for global trade to be priced in U.S. dollars, contributing to the U.S. dollar’s status as the world’s reserve currency.
Financial Developments 55 3.4.4.1 Commodities Futures & Options: Open Interest Over the past five years, the notional amount 3.4.4.1 Commodities Futures & Options: Open Interest of U.S. futures and options outstanding has Trillions of US$ As Of: Jul-2020 Trillions of US$ averaged approximately $1.5 trillion (Chart 2.5 2.5 Options 3.4.4.1). Commodity exchange-traded products Futures 2.0 2.0 (ETPs), which provide retail investors with a vehicle to gain exposures to commodity 1.5 1.5 markets, saw significant growth in net AUM during the first nine months of 2020 (Chart 1.0 1.0 3.4.4.2). Commodity ETP growth has been driven by inflows into bullion-backed gold 0.5 0.5 ETFs, as investors sought to gain portfolio diversification in a low-yield environment. 0.0 0.0 2015 2016 2017 2018 2019 2020 Note: Notional amount outstanding. Options are Precious and Industrial Metals Source: CFTC not delta-adjusted Between 2015 and 2019, gold and other precious metals traded in a relatively narrow price band. During the extreme volatility observed in March 2020, precious metals sold off substantially. 3.4.4.2 Total Net Asset Value – Commodity ETFs 3.4.4.2 Total Net Asset Value: Commodity ETFs Despite gold’s typical position as a safe haven Billions of US$ As Of: Sep-2020 Billions of US$ asset, gold prices fell by approximately 12 160 160 percent between March 9 and March 19 as 140 140 investors and central banks sought to raise 120 120 dollars amid the global flight to liquidity. Since 100 100 then, precious metals have rallied considerably
80 80 (Chart 3.4.4.3). Gold and silver have driven this recovery in precious metals prices, with 60 60 gold futures reaching an all-time high of $2,089 40 40 per troy ounce on August 7 and silver futures 20 20 rising to a seven-and-a-half-year high of almost 0 0 2015 2016 2017 2018 2019 2020 $30 per troy ounce on the same day. Physically- Note: Data are as of end of September in backed ETF holdings for gold and silver have Source: Morningstar, Inc. each given year. also surged in 2020, as investors use these instruments to gain exposure to rising prices. While platinum and palladium prices have recovered from their March 2020 lows, as of 3.4.4.3 Metals Indices September 30, 2020, they were still 13 percent 3.4.4.3 Metals Indices and 19 percent, respectively, below their pre- Index As Of: 30-Sep-2020 Index 175 175 pandemic highs, which can be attributed to increased uncertainty around future demand 150 Bloomberg Precious 150 given that these metals are used in automotive Metals Index catalysts to reduce emissions. 125 125 Similar to other commodities, industrial 100 100 metals prices dropped steeply in March and April 2020 as COVID-19 lockdowns depressed 75 75 demand from the manufacturing and Bloomberg Industrial Metals Index construction industries. Global markets have 50 50 2015 2016 2017 2018 2019 2020 since rebounded on strong China demand, Source: Bloomberg, L.P. Note: Indexed to 01-Jan-2015. government stimulus efforts, and a lower U.S.
56 2020 FSOC // Annual Report dollar. Iron ore prices increased significantly 3.4.4.4 Cash-Futures Spread: Gold since April due to a reduction of stocks, which 3.4.4.4 Cash-Futures Spread: Gold were impacted by a slowdown in seaborne Price Per Ounce (US$) As Of: 31-Jul-2020 Spread Per Ounce (US$) 2200 75 supply during the first quarter, and Chinese steelmakers ramping up production in the 2000 50 second quarter. Helping to support aluminum prices, U.S. tariffs were re-imposed on 1800 25 unalloyed, unwrought aluminum imports from Canada on August 16. 1600 0
1400 Spread (right axis) -25 Gold markets experienced significant price Cash: London Bullion (left axis) Futures: COMEX (left axis) dislocations at the height of the COVID-19 1200 -50 market stress. For example, the New York Jan:2020 Mar:2020 May:2020 Jul:2020 COMEX gold futures price diverged materially Note: London 4:00pm fix minus COMEX Source: Bloomberg, L.P., CFTC 10:00am volume weighted average price. from the London spot price, which can largely be attributed to supply chain disruptions and contract specifications. Typically, if there is a shortage of gold at COMEX, gold refineries 3.4.4.5 Agriculture Prices will recast 400 ounce London bullion bars 3.4.4.5 Agriculture Prices into the 100-ounce bars that are required to Index As Of: 24-Sep-2020 Index settle futures contacts in New York. Increased 120 120 demand for gold coupled with disruptions in Lean Hogs Sugar Soybeans Wheat 110 Live Cattle Cotton Corn 110 air travel and shutdowns at major refineries, however, raised concerns that there could be a 100 100 shortage of 100-ounce COMEX bars at the time 90 90 of settlement. At the height of the COVID-19 crisis, the spot and futures price spread widened 80 80 to over $50 per ounce (Chart 3.4.4.4). 70 70
Agriculture Markets 60 60 Dec:2019 Feb:2020 Apr:2020 Jun:2020 Aug:2020 COVID-19 impacted the agricultural markets in numerous ways, including multiple price Source: Bloomberg, L.P., CFTC Note: Indexed to year-end 2019. distortions, increased volatility, and significant dislocations. Some agricultural products, like milk and bacon, faced a supply glut due to the sharp drop off in purchases from restaurants and other commercial end-users, while others, such as ground beef, saw shortages due to rolling shutdowns of meatpacking factories with COVID-19 infections. Temporary government payment programs have helped stave off farm bankruptcies, but the outlook for the sector is uncertain.
Most agricultural commodity prices fell sharply with the pandemic, declining by anywhere from 10 percent to 35 percent in March and April (Chart 3.4.4.5). Agricultural markets were also down before the pandemic due to trade
Financial Developments 57 disruptions with China and bearish supply and 3.4.4.6 Cash-Futures Spread: Cattle 3.4.4.6 Cash-Futures Spread: Cattle demand fundamentals. The gradual lifting Price Per 100lbs As Of: 30-Sep-2020 Price Per 100lbs of virus restrictions, a pick-up in Chinese 500 150 purchases, and a weaker U.S. dollar relative Cash: Boxed Beef (left axis) Futures: Live Cattle 140 Spread (left axis) (right axis) to the April 2020 peak, have all provided 400 130 support to most agricultural markets. By the
300 120 end of September, prices for most agricultural 110 products have returned to pre-pandemic
200 100 levels. However, livestock prices were still down approximately 10 percent year-to-date through 90 100 September 30, 2020. Price volatility, which 80 declined over the summer, remained elevated 0 70 Jan:2020 Mar:2020 May:2020 Jul:2020 Sep:2020 relative to pre-pandemic levels. Note: Box beef choice cut prices Source: Bloomberg, L.P., CFTC minus live cattle front month contract In March 2020, the shutdown in economic activity and the rapid change in consumer behavior led to dislocations between futures and underlying cash markets for various 3.4.4.7 Net Farm Income 3.4.4.7 Net Farm Income commodities. During this period, retail beef Billions of US$ As Of: 2-Sep-2020 Billions of US$ and pork prices spiked due to an increase 175 175 Other Direct Farm Programs in consumer demand related to stockpiling, 150 Market Facilitation Program 150 COVID-19 Programs coupled with a decline in supply due to Net Income (excl. Direct Farm Programs) 125 125 COVID-19 outbreaks at meat processing plants. By mid-May, beef and pork production was 100 100 40 percent below 2019 levels. As processing 75 75 plants struggled to remain open, demand for 50 50 live cattle and lean hogs fell, which pushed 25 25 futures prices lower, and by mid-May, the spread
0 0 between choice boxed-beef (cash markets) and 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020F live cattle (futures) in particular was driven Note: The Market Facilitation Program provides direct payments to help producers who have been directly impacted by illegal retaliatory to historical highs (Chart 3.4.4.6). Given the Source: USDA tariffs. COVID-19 Programs include $16 billion in Coronavirus Food Assistance Program payments and $5.8 billion in PPP payments. unprecedented challenges facing the livestock industry, the CFTC has formed a Livestock Taskforce to monitor events in the agriculture market.
According to the September 2020 United States Department of Agriculture (USDA) forecast, net farm income is projected to increase to $103 billion in 2020, which can largely be attributed to a significant increase in direct government payments (Chart 3.4.4.7). Direct government payments are projected to total $37 billion in 2020, or 36 percent of net farm income. These programs have helped offset the decline in cash receipts for all commodities, which are projected to decrease to $358 billion in 2020, down $12 billion from 2019. The bulk of 2019 and 2020 direct federal government payments
58 2020 FSOC // Annual Report can be attributed to the Market Facilitation 3.4.4.8 Energy Futures & Options: Open Interest Program, which provides temporary assistance 3.4.4.8 Energy Futures & Options: Open Interest to farmers in response to trade disruptions, and Billions of US$ As Of: Jul-2020 Billions of US$ 2000 2000 COVID-19 disaster assistance programs. Options Futures Prior to the COVID-19 pandemic, the 1500 1500 agricultural sector faced stress due to low commodity prices, U.S.-China trade tensions, 1000 1000 and the severe flooding in the Midwest. Federal assistance programs and forbearance programs 500 500 have helped keep family farms afloat through the COVID-19 pandemic. In fact, the number of family farms filing for bankruptcy under 0 0 2015 2016 2017 2018 2019 2020 Chapter 12 fell to 284 in the first six months of Source: CFTC 2020 compared to 294 in the first six months of 2019. Nevertheless, the outlook for the sector remains uncertain.
3.4.4.9 Energy Futures & Options by Product Energy Markets 3.4.4.9 Energy Futures & Options by Product The U.S energy futures markets are critical Percent As Of: Jul-2020 Percent for the U.S. economy, spanning petroleum 100 100 products, natural gas, and electricity (Charts 80 80 3.4.4.8, 3.4.4.9). These markets are central to price formation and price discovery for 60 60 various producers, refiners, storage providers, intermediaries, and distributors, and serve 40 40 as key benchmarks to price-related cash transactions and associated swap, ETF, and 20 20 commodity index products that attract a 0 0 broader set of investors. 2015 2016 2017 2018 2019 2020 Electricity Natural Gas Petroleum In the months leading up to the COVID-19 Source: CFTC pandemic, crude oil prices were trending upwards due to more positive economic conditions and a thawing in global trade tensions. By year-end 2019, the West Texas Intermediate (WTI) spot price was $61 per barrel, up from $54 per barrel on September 30, 2019. In late-January, crude oil prices began trending lower, as investors anticipated lower Chinese demand amid the COVID-19-related lockdowns and travel restrictions. The decline in crude oil prices rapidly accelerated in March as global demand collapsed and Saudi Arabia and Russia failed to reach an agreement on production cuts. By March 30, WTI fell to a seventeen-year low of $14 per barrel. By April 2020, global demand for liquid fuel fell to an estimated 81 million barrels per day, while
Financial Developments 59 global production remained fairly constant at 3.4.4.10 Global Petroleum Consumption and Production 3.4.4.10 Global Petroleum Consumption and Production 100 million barrels per day (Chart 3.4.4.10). Millions of Barrels As Of: Sep-2020 Millions of Barrels The resulting growth in crude oil inventories 115 30 Consumption (left axis) Change in Inventories led to concerns that oil production in the U.S. Production (left axis) (right axis) 20 midcontinent could overwhelm storage capacity 105 in the trading hub of Cushing, Oklahoma. In 10 light of these storage constraints, the front- 95 0 month WTI oil futures contract began trading
-10 negative for the first time in history, settling to 85 a record low -$38 per barrel on April 20, 2020 -20 (Chart 3.4.4.11). WTI futures quickly returned 75 -30 to positive levels, however, as it became clear 2015 2016 2017 2018 2019 2020 that regional facilities were likely adequate to Note: Millions of barrels per day. Change in Source: U.S. Energy inventories represents the difference between manage near-term oil storage needs. Information Administration production and consumption.
In May, WTI oil prices rebounded sharply and have since stabilized around $40 per barrel amid sustained production cuts by 3.4.4.11 WTI Crude Oil Futures 3.4.4.11 WTI Crude Oil Futures the Organization of Petroleum Exporting Price Per Barrel (US$) As Of: 30-Sep-2020 Price Per Barrel (US$) Countries (OPEC) and its partner countries, 100 100 declining U.S. crude supplies, and recovering WTI 3rd Month 75 WTI Front Month 75 demand. In April 2020, OPEC and Russia (OPEC+) agreed to reduce oil production by 50 50 about 9.7 million barrels per day from October
25 25 2018 production levels in order to address the challenge of global oversupply. OPEC+ has 0 0 maintained significant cuts into the second half
-25 -25 of 2020, with some adjustments. The decline in production while global economies reopened -50 -50 2016 2017 2018 2019 2020 ultimately helped rebalance markets, although demand for refined products remains well Source: U.S. Energy Information Administration below seasonal levels.
Prior to the COVID-19 pandemic, natural gas inventories were elevated as the relatively mild 3.4.4.12 Natural Gas Inventories winter led to lower consumption during the 3.4.4.12 Natural Gas Inventories 2019-2020 heating season. The pandemic led to Billions of Cubic Feet As Of: 25-Sep-2020 Billions of Cubic Feet 5000 5000 a sharp decline in commercial and industrial Weekly Natural Gas Inventories 5-Year Range demand for natural gas, with a delayed 5-Year Average 4000 4000 production response leading to the highest seasonal inventory levels in five years 3000 3000 (Chart 3.4.4.12).
2000 2000 Similar to natural gas inventories, the natural 1000 1000 gas futures curve typically exhibits seasonality, with summer contracts trading at a discount 0 0 relative to winter contracts. Beginning in mid- 2017 2018 2019 2020 March, this spread widened considerably, as Source: U.S. Energy Note: The shaded area and dotted line indicate Information Administration the rolling 5-year range and average. the reduction in demand and high inventory
60 2020 FSOC // Annual Report levels put downward pressure on the front of 3.4.4.13 Natural Gas Forward Curves the futures curve, while anticipated production 3.4.4.13 Natural Gas Forward Curves cuts kept the back end of the curve relatively Price Per MMBtu (US$) As Of: 26-Jun-2020 Spread per MMBtu (US$) stable. A summer to winter differential of greater 4.0 1.5 than 60 cents is rarely seen in natural gas, and January 2021 Futures Contract Spread (right axis) 3.5 (left axis) 1.2 yet the spread between the July 2020 contract July 2020 Futures Contract and January 2021 contract exceeded $1.30 per 3.0 (left axis) 0.9 million British thermal units in the week prior to 2.5 the July 2020 contract expiration 0.6 (Chart 3.4.4.13). 2.0
0.3 1.5 3.4.5 Residential Real Estate Markets 3.4.5.1 Residential Housing Finance 1.0 0.0 Sep:2019 Dec:2019 Mar:2020 Jun:2020 Real estate markets and home prices continued Source: Bloomberg, L.P. their steady, upward long-run path during the first quarter of 2020, just prior to the COVID-19 crisis. Nationally, house prices rose by 6.1 percent between the first quarter of 2019 3.4.5.1 House Prices by Census Division and the first quarter of 2020, according to 3.4.5.1 House Prices by Census Division the seasonally adjusted, purchase-only FHFA Index As Of: Aug-2020 Index 450 450 House Price Index® (HPI). Across census Mountain 400 Pacific 400 divisions, gains were highest in the Mountain West South Central division, which posted an 8.8 percent year-over- 350 South Atlantic 350 West North Central year price increase. The majority of the U.S., 300 Total U.S. 300 New England including all of the top 100 largest metropolitan 250 East South Central 250 Middle Atlantic statistical areas, experienced positive growth. In 200 East North Central 200 general, prices were buoyed by a combination of 150 150 historically low interest rates, a healthy economy 100 100 characterized by low unemployment (until the 50 50 spring), and a constrained supply of houses 1991 1995 1999 2003 2007 2011 2015 2019 available for sale. Although not unaffected by Source: Federal Housing Note: Purchase-only, seasonally adjusted, nominal, the COVID-19 pandemic, housing has been Finance Agency constant-quality price index. January 1991 = 100. remarkably resilient in part due to substantial government support of both renters and homeowners.
Between August 2019 and August 2020, FHFA’s HPI increased 8.0 percent for the nation, while census division gains ranged from a low of 7.2 percent in the West North Central division to a high of 9.7 percent in the Mountain division (Chart 3.4.5.1). The monthly decline of 0.2 percent from April to May likely reflected the muted impact of the COVID-19 pandemic on the housing market. During this spring period, many states were under broad stay-at- home orders and many individuals engaged in voluntary social distancing efforts to combat the spread of COVID-19. These actions led
Financial Developments 61 to a decrease in overall economic activity, 3.4.5.2 Home Sales 3.4.5.2 Home Sales including the temporary halting or slowing of Millions of Sales As Of: Aug-2020 Millions of Sales many activities like construction, real estate 1.2 6.5 showings, interior appraisals, and in-person Existing Home Sales 6.0 closings. Together these factors appear to have 1.0 (right axis) temporarily dampened sales activity. 5.5
0.8 5.0 As a result of the pandemic, existing home
New Home Sales 4.5 sales fell from 5.8 million sales in February to 0.6 (left axis) 3.9 million in May on a seasonally adjusted, 4.0 annualized basis. Existing home sales have since
0.4 3.5 rebounded to 6.0 million in August 2020 (Chart 2015 2016 2017 2018 2019 2020 3.4.5.2). Similarly, new home sales fell markedly Source: NAR, Census Note: Series are seasonally adjusted annual rates and in March and April, but have since rebounded Bureau, HUD are expressed in millions of single-family housing units. to over 1 million in August 2020, well above pre- pandemic levels. Low interest rates and strong growth in purchase mortgage applications and pending home sales in the third quarter suggest 3.4.5.3 New Housing Starts and Price Changes 3.4.5.3 New Housing Starts and Price Changes that this rebound will continue in the near Millions of Housing Units As Of: Aug-2020 Percentage Change term. Beyond this time frame, the path of the 2.5 15 employment recovery and limitations on the House Price Changes 10 supply of homes for sale could constrain sales 2.0 (right axis) growth. 5 1.5 0 According to Realtor.com, the inventory of 1.0 Housing Starts existing homes for sale was lower in September -5 (left axis) by nearly 40 percent compared to the prior 0.5 -10 year. In the face of this tight housing supply, new home sales rose to the highest levels 0.0 -15 2000 2003 2006 2009 2012 2015 2018 observed since 2006 as demand spilled over Source: U.S. Census Note: Data are seasonally adjusted annual rates. House Price Changes series is the year-over-year percentage into new construction. In response, single- Bureau, FHFA, HUD change of the FHFA National House Price Index. family housing starts are expected to increase during the remainder of the year, so long as land for building permits remains available and demand is sustained. Creating new housing supply continues to remain a challenge for the U.S., with new starts only sluggishly responding since the last housing crisis despite persistent increases in home prices (Chart 3.4.5.3).
According to the Census Bureau, the national homeownership rate rose from 64 percent in the first quarter of 2019 to 65 percent in the first quarter of 2020. While this is down from the all-time high of 69 percent in 2004, the June reading was above the average homeownership rate for the preceding 30 years. Following the Great Recession, the homeownership rate fell to a low of 63 percent in the second quarter of
62 2020 FSOC // Annual Report 2016 – the lowest rate in decades. Rental vacancy 3.4.5.4 Homeownership and Vacancy Rates rates have also improved, falling from the five- 3.4.5.4 Homeownership and Vacancy Rates year average of 6.9 percent to 6.6 percent in the Percent As Of: 2020 Q1 Percent first quarter of 2020 (Chart 3.4.5.4). 66 9
Mortgage Originations, Servicing, and 65 8 Loan Performance According to the Freddie Mac Primary 64 7 Mortgage Market Survey®, the average 30- Rental Vacancy Rate (right axis) year fixed mortgage rate dropped 81 basis 63 6 Homeownership Rate points during 2019 and has continued to (left axis) decline through 2020. In the first nine months 62 5 2015 2016 2017 2018 2019 2020 of 2020, the average 30-year fixed mortgage Source: U.S. Census Bureau, Current Note: Data are non-seasonally rate decreased a further 84 basis points to 2.9 Population Survey/Housing Vacancy Survey adjusted quarterly percentages. percent as of September 2020. This decline in rates has helped to sustain borrower demand and increase the attractiveness of both purchase and refinance mortgages. Primary 3.4.5.5 Mortgage Originations and Rates mortgage rates, which often track 10-year U.S. 3.4.5.5 Mortgage Originations and Rates Treasury yields, have not declined as much as Billions of US$ As Of: 2020 Q2 Percent 800 6 10-year U.S. Treasury yields, which fell by 123 Refinance (left axis) Purchase (left axis) basis points year-to-date through September 30, 30-Year Mortgage 2020. The economic uncertainty surrounding 600 Rate (right axis) 5 the COVID-19 pandemic and the growth in origination volumes due to lower rates have left 400 4 primary mortgage to Treasury yield spreads somewhat elevated, though the spread has 200 3 narrowed compared to early in the COVID-19 crisis as a result of Federal Reserve market 0 2 interventions. 2015 2016 2017 2018 2019 2020 Source: NMDB®, Freddie Mac Note: Quarterly originations represent all 1-4 family homes with first-lien, closed- ® Based on the National Mortgage Database Primary Mortgage Market Survey end residential mortgages. (NMDB®), refinance originations remained robust in 2020, rising to $396 billion in the second quarter of 2020 as mortgage rates reached their lowest levels in decades (Chart 3.4.5.5). This was an increase in refinance originations of $191 billion from the second quarter of 2019. Over the same time period, home purchase originations decreased from $315 billion to $215 billion.
The market share of different types of mortgage originators has changed over time. Non- depository institutions have been expanding their share of the mortgage origination market in recent years. As tracked in Home Mortgage Disclosure Act data, the non-depository share of mortgage originations was approximately 60
Financial Developments 63 percent in 2019 compared to approximately 30 3.4.5.6 Purchase Origination Volume by Credit Score 3.4.5.6 Purchase Origination Volume by Credit Score percent in the years prior to the 2008 financial Percent of Originations As Of: 2020 Q2 Percent of Originations crisis. In recent years, depository institutions 100 100 with assets between $100 billion and $1 trillion >780 have increased their share of originations, 80 80 from 11 percent of total depository originations
60 60 in 2016 to 18 percent in the first half of 2020 661-780 according to Inside Mortgage Finance. The 40 40 share of depository institution originations by banks with assets between $10 and $100 billion 20 601-660 20 has increased from 16 percent in 2016 to 26 <601 percent in the first half of 2020. Over that time, 0 0 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 the market shares of the largest depositories
Note: Based on first-borrower VantageScore 3.0 for (over $1 trillion in assets) and the smallest Source: NMDB® first-lien, closed-end residential purchase mortgages. depositories (less than $10 billion in assets) have decreased.
Credit quality of new purchase mortgages 3.4.5.7 Shares of Mortgages by Equity Percentage 3.4.5.7 Shares of Mortgages by Equity Percentage remained relatively strong through the first Percent As Of: 2020 Q2 Percent half of 2020 (Chart 3.4.5.6). The percentage 100 100 of borrowers with scores in the middle of the <0% credit spectrum (VantageScore 3.0 scores 80 0 to <5% 80 5 to <20% between 661 and 780) remained relatively 60 60 stable at approximately 50 percent for the last two decades. The highest credit quality group, 40 Percentage of mortgages with 40 borrowers with scores at or above 781, saw their 20% or more equity share gain steadily since the 2008 financial 20 20 crisis, and represented around 30 percent of the market as of the second quarter of 2020. 0 0 2000 2002 2004 2006 2008 2011 2013 2015 2017 2019 The percentage of borrowers in the lowest score
Note: Quarterly percentage of all mortgage categories (below 661) declined from a high Source: NMDB® loans that are not closed or terminated. of 36 percent in the first quarter of 2006 to a low of 8.8 percent in the third quarter of 2012 before increasing to 15 percent in the second quarter of 2020.
Positive equity continued to strengthen, with 90 percent of active mortgages having 20 percent or more of positive equity in the home, and over 99 percent of mortgages having at least 5 percent of positive equity as of the second quarter of 2020 (Chart 3.4.5.7). Recent improvement to borrower equity positions has been driven in part by more than eight years of house price appreciation, providing a stark contrast with the bottom of the last housing cycle. Over the last two decades, positive equity reached its lowest point in the third quarter of
64 2020 FSOC // Annual Report 2012, with only 61 percent of borrowers holding 3.4.5.8 Mortgage Delinquency equity of 20 percent or more. 3.4.5.8 Mortgage Delinquency Percent As Of: 2020 Q2 Percent 6 6 In response to the unprecedented level of 90 to 180 Days unemployment claims caused by the pandemic, 5 Past Due 5 federal and state governments enacted a 4 30 or 60 Days 4 series of public assistance policies to support Past Due 3 3 household incomes, suspend foreclosures and In process of evictions, and offer flexibility in home purchase 2 foreclosure, 2 bankruptcy or and mortgage acquisition processes. Under 1 deed-in-lieu 1 the CARES Act, borrowers with a federally backed mortgage are able temporarily to 0 0 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 request mortgage payment forbearance, and the CARES Act specifies that loans that were Note: Quarterly percentage of all mortgage Source: NMDB® loans that are not closed or terminated. current when they entered forbearance must be subsequently reported as current even when borrowers are not making payments. As a result, mortgage performance, as reported to the credit bureaus and reflected in the NMDB, differs from mortgage performance reported directly by mortgage servicers; for example, in Mortgage Bankers Association surveys, loans in forbearance are reported as delinquent if the payment was not made based on the original terms of the mortgage.
As a potential consequence of these policies, the percentage of borrowers who were reported to the credit bureaus as being in the process of foreclosure, bankruptcy, or deed-in-lieu remained stable at 0.3 percent from the fourth quarter of 2019 to the second quarter of 2020 (Chart 3.4.5.8). Following the CARES Act, the percentage of borrowers reported to the credit bureaus as 30 or 60 days past due dropped from 2.0 percent in the first quarter of 2020 to 1.0 percent in the second quarter. Similarly, the percentage of borrowers reported as 90 to 180 days past due dropped from 0.9 to 0.7 percent in the same time period. However, as noted above, some of this decline may be due to the CARES Act reporting requirements, and thus may not be reflective of borrowers’ true economic circumstances. The Mortgage Bankers Association’s National Delinquency Survey, for example, estimated a 7.7 percent delinquency rate in the third quarter of 2020, an increase of 3.7 percentage points from a year ago.
Financial Developments 65 3.4.5.9 Forbearance Rates by Investor Type Forbearance rates were relatively low prior to 3.4.5.9 Forbearance Rates by Investor Type COVID-19, with total single-family forbearance Percent As Of: Sep-2020 Percent rates at just 1.1 percent in March 2020. After 16 16 FHA, VA, and RHS the passage of the CARES Act, forbearance Total rates jumped quickly to 6.1 percent in April and 12 GSE 12 Other (PLS, Portfolio, etc.) peaked at 7.2 percent in May (Chart 3.4.5.9). Forbearance rates were higher for certain 8 8 investor products and programs.
4 4 Not all borrowers that have requested forbearance have actually missed payments, and
0 0 not all delinquent borrowers that are eligible Mar:2020 Apr:2020 May:2020 Jun:2020 Jul:2020 Aug:2020 Sep:2020 for forbearance have entered forbearance Note: Rates are the weekly percentage of servicing programs. Nonetheless, forbearances had Source: NMDB® portfolio volume in forbearance by investor type over time. an immediate and significant benefit for borrowers; more than half of borrowers in forbearance did not make their June mortgage payment but were reported as current. Overall, this represents about 3.4 percent of all outstanding mortgages which, if treated as being late with payments, would have more than doubled the national mortgage delinquency rate. The path of the economic recovery and the impact on servicers of the additional costs of non-paying loans remains uncertain. The refinance boom, however, has simultaneously provided servicers with a temporary source of liquidity to help sustain operations.
The average credit score (VantageScore 3.0) of mortgage borrowers increased by about 9 points in July 2020 compared to December 2019. Credit score decreases of 20 points or more were only seen in about 10 percent of borrowers. The absence of a negative COVID- effect on credit scores may be in part due to the CARES Act’s provision for creditors to continue to report borrowers granted a COVID related workout according to their pre-pandemic payment status. For borrowers with mortgage forbearance, decreasing credit scores may indicate growing problems with their non- mortgage obligations, though forbearance is available in some instances for other credit obligations, such as auto loans.
66 2020 FSOC // Annual Report 3.4.5.2 Government-Sponsored Enterprises and the 3.4.5.10 Mortgage Originations by Product Secondary Mortgage Market 3.4.5.10 Mortgage Originations by Product The federal government continues to back Percent of Originations As Of: 2019 Q4 Percent of Originations 100 100 the majority of new mortgages either directly through the Federal Housing Administration 80 Private Portfolio 80 (FHA), the U.S. Department of Veterans Affairs and Securitized (VA), and the USDA, or indirectly through 60 60 Fannie Mae and Freddie Mac (the Enterprises). GSE The federal government share of mortgage 40 40 originations—which averaged 77 percent over the past decade—was 73 percent at the end of 20 20 FHA, VA & RHS 2019 (Chart 3.4.5.10). However, this share has 0 0 increased since the onset of COVID-19, as the 1998 2001 2004 2007 2010 2013 2016 2019 government has performed its countercyclical Note: Quarterly data for first-lien, Source: NMDB® closed-end residential mortgages. role of maintaining the flow of credit.
The COVID-19 pandemic resulted in a contraction of both portfolio lending and 3.4.5.11 RMBS Issuance private-label securitizations. New mortgages 3.4.5.11 RMBS Issuance not securitized by Ginnie Mae (GNMA) or the Trillions of US$ As Of: Sep-2020 Trillions of US$ Enterprises continue to be held mostly in lender 3.5 3.5 Nonagency portfolios rather than securitized in the private- 3.0 Agency 3.0 label market. Non-agency RMBS issuance 2.5 2.5 totaled $63 billion in 2019, but only $12 billion 2.0 2.0 in the first half of 2020. This is the second 1.5 1.5 consecutive year with an over 60 percent decline compared to the same period during the prior 1.0 1.0 year (Chart 3.4.5.11). In contrast, agency RMBS 0.5 0.5 issuance totaled $1.3 trillion in the first six 0.0 0.0 months of 2020, almost double that of the same 2004 2006 2008 2010 2012 2014 2016 2018 2020 YTD period in 2019, and reached $2.3 trillion by Source: FHLMC, FNMA, GNMA, NCUA, FDIC, September 2020. Bloomberg, L.P., Dealogic, Thomson Reuters, SIFMA
A notable change in early 2020 has been the early and persistent federal response to the COVID-19 pandemic. The FHFA, CFPB, and HUD have worked together to provide assistance under the CARES Act in the form of temporary mortgage relief, payment suspensions, protection for renters, remittance transfers, and informational resources (see Section 4.5). Also, as it had done during the 2008 financial crisis, the Federal Reserve quickly restarted its open market operations to stabilize financial markets when volatility began to increase in the middle of March 2020. The Federal Reserve’s agency MBS purchases totaled approximately $560 billion through the end of April and $1.1 trillion by the end of
Financial Developments 67 September 2020 (Chart 3.4.5.12). The pace of 3.4.5.12 Cumulative MBS Purchases by the Federal Reserve 3.4.5.12 Cumulative MBS Purchases by the Federal Reserve Federal Reserve purchases has slowed as market Billions of US$ As Of: 30-Sep-2020 Billions of US$ functioning stabilized. 1250 1250 UMBS GNMA 1000 1000 Fannie Mae and Freddie Mac The Enterprises, currently in their thirteenth 750 750 year of conservatorship, are an important source of liquidity to the mortgage market 500 500 and of stability to the housing market. After the onset of the pandemic, the Enterprises 250 250 took numerous actions at the direction of FHFA to support borrowers and renters, such 0 0 Mar:2020 Apr:2020 May:2020 Jul:2020 Aug:2020 Sep:2020 as suspending foreclosures and evictions. Note: Cumulative 2020 purchases. Weekly series are aggregated While the full costs of the pandemic are yet Source: FRBNY from daily Agency MBS operations in the TBA pool. to be realized, the Enterprises continue to be profitable. The Enterprises reported net income of $3.4 billion during the second quarter of 2020, an increase from $1.1 billion in income during the first quarter of 2020.
The Enterprises’ single-family and multifamily books of business increased over the last year. The Enterprises’ single-family guaranty book of business increased to $5.1 trillion as of June 30, 2020, a 5 percent increase from June 30, 2019. This was partially driven by the Enterprises’ 77 percent increase in new business activity in the second quarter of 2020 compared to the first quarter of 2020. The Enterprises’ multifamily portfolios increased to $639 billion, or by 12 percent, in the second quarter of 2020, compared to the same period in 2019.
The Enterprises have been transitioning financial instruments to SOFR and away from LIBOR. LIBOR may not be published after year- end 2021, requiring a transition of all financial instruments referencing the rate. FHFA worked with the Enterprises to develop parameters for a SOFR adjustable-rate mortgage (ARM) along with fallback language for replacement rates. Transition announcements were released in February 2020 and a transition playbook was issued in May. Fannie Mae and Freddie Mac will each cease issuance of single-family and multifamily LIBOR-based credit risk transfer (CRT) transactions in December 2020. LIBOR-based ARMs
68 2020 FSOC // Annual Report will no longer be purchased with maturities Federal Home Loan Banks beyond 2021. The FHLBs continued to serve as an important source of liquidity for the mortgage market and to exhibit The Enterprises have continued to transfer strong financial performance. From June 30, 2019 risk to private capital in the mortgage market to June 30, 2020, the FHLBs reported aggregate net and reduce taxpayer risk through their CRT income of $2.9 billion, which is moderately down transactions. Fannie Mae has primarily compared to recent years. transferred risk through its issuance of Connecticut Avenue Securities and Credit Total assets decreased $130 billion over the same Insurance Risk Transfer transactions. In 12-month period, but there were significant 2019, Fannie Mae transferred a portion of fluctuations in 2020. The total assets of the FHLBs the credit risk on single-family mortgages have decreased from $1.3 trillion on March 31, 2020 to with unpaid principal balance (UPB) of $1.0 trillion as of June 30, 2020. Advances, the largest $488 billion and risk-in-force of $15 billion. component of FHLB assets, are a loan product FHLBs Since inception of its risk transfer programs, extend to their members to help them meet short Fannie Mae has transferred a portion of the and long-term liquidity and housing finance needs. credit risk on single-family mortgages with Advances increased by 26 percent in the first quarter UPB of nearly $2.1 trillion through 2019. of 2020 and reached their post-2008 crisis peak of Fannie Mae has not entered into a new CRT $807 billion as a result of the market crisis caused by transaction, however, since the first quarter the pandemic. As market volatility subsided and FHLB of 2020. Freddie Mac transferred a portion members’ liquidity needs decreased, advances fell by 31 of the credit risk on $220 billion in UPB of percent, to $558 billion, by June 30, 2020. single-family mortgage loans in 2019 with risk-in-force of $8.8 billion, primarily through While assets decreased primarily due to a decline in its issuance of Structured Agency Credit Risk advances, mortgage holdings purchased from FHLB securities and through its Agency Credit members continued to increase at the FHLBs. From Insurance Structure transactions. Through the June 30, 2019, to June 30, 2020, mortgages increased first three quarters of 2020, Freddie Mac has $6.4 billion to $73 billion. Additionally, retained transferred $12 billion of risk-in-force on $309 earnings continued to grow at the FHLBs, increasing billion of UPB. Since it began undertaking to $21 billion on June 30, 2020, an all-time high for the CRTs, Freddie Mac has executed transactions FHLB System. covering over $1.7 trillion in UPB for single- family mortgages through September 2020. 3.4.6 Commercial Real Estate Market With the onset of the global pandemic, commercial In September 2019, Treasury and the FHFA real estate (CRE) experienced significant challenges in agreed to modifications to the Preferred the first three quarters of 2020 stemming from public Stock Purchase Agreements (PSPAs) that health measures taken in response to COVID-19. In permit Fannie Mae and Freddie Mac to retain particular, pandemic-imposed travel restrictions and $25 billion and $20 billion in earnings, mandatory and voluntary social distancing efforts respectively. Net worth in excess of these accelerated the decline in brick and mortar retail and limits would be paid out to the Treasury as adversely impacted occupancy of hotel CRE properties. dividends. Through June 30, 2020, dividends to the Treasury have totaled $301 billion, with The CRE loan delinquency rate has increased cumulative dividends paid by Fannie Mae and significantly for those loans whose underlying Freddie Mac totaling $181 billion and $120 properties experienced severe pandemic-induced billion, respectively. cash flow disruptions. The percent of seriously delinquent loans in non-agency conduit CMBS deals— as measured by loans that have been delinquent for 60 days or more, as well as those in collateral
Financial Developments 69 foreclosure—increased from 2.2 percent in 3.4.6.1 Conduit CMBS Delinquency and Foreclosure Rate 3.4.6.1 Conduit CMBS Delinquency and Foreclosure Rate May to 6.9 percent in September. The rate of Percent As Of: Sep-2020 Percent seriously delinquent loans peaked at 7.1 percent 10 10 in July, its highest level since 2013 (Chart 3.4.6.1). 8 8
6 60+ Days 6 Loan delinquencies vary widely across property Delinquent sectors (Chart 3.4.6.2). As of September 2020, 4 4 loans in conduit CMBS deals collateralized by Foreclosure / lodging properties, such as hotels, represent the 2 Real Estate 2 highest percentage of seriously delinquent loans Owned at 19 percent, followed by loans collateralized 0 0 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 by retail properties at 11 percent. Industrial, multifamily, and office loans have the lowest Source: JPMorgan, Trepp Note: Delinquency rate includes FC/REO. CRE delinquency rates of 1.2 percent, 2.1 percent, and 2.2 percent, respectively. Though office loans have relatively low delinquency rates, there is a high degree of uncertainty 3.4.6.2 Conduit CMBS Delinquency Rates by Industry 3.4.6.2 Conduit CMBS Delinquency Rates by Industry with respect to the long-term impact of the Percent As Of: Sep-2020 Percent pandemic on office properties, due to large 20 20 numbers of people teleworking. Industrial Office 15 Retail 15 Pursuant to the CARES Act, FHFA and HUD Lodging Multifamily announced that they would offer forbearance to multifamily property owners affected by 10 10 COVID-19, to help ease the financial burden stemming from public health measures. 5 5 Lenders may not charge borrowers under a forbearance any late fees or proceed with 0 0 evictions for tenants for the duration of their 2017 2018 2019 2020 forbearance. Not all multifamily renters and Source: JPMorgan, Trepp Note: 60+ delinquency rate; includes FC/REO. owners, however, are eligible for this assistance. Fannie Mae and Freddie Mac have provided explicit guidance that renters are permitted to receive eviction moratoria during the forbearance period, while the property owners can seek temporary mortgage relief if the loan qualifies for forbearance. At the end of September, 95 percent of renters had made their monthly rent payments according to the National Multifamily Housing Council’s analysis of data collected on approximately 11 million rental units, compared to 96 percent for September 2019. As of September 2020, the percentage of Enterprise multifamily loans in forbearance remains low—about 1.3 percent for Fannie Mae and 2.2 percent for Freddie Mac. The pace of growth in forbearance appears to have slowed down for both Fannie Mae and
70 2020 FSOC // Annual Report Freddie Mac as the market has improved, but 3.4.6.3 CMBS Issuance warrants continued monitoring. In addition, 3.4.6.3 CMBS Issuance student and senior housing properties, as well Billions of US$ As Of: 2020 Q3 Billions of US$ 300 300 as multifamily properties with smaller units, Non-Agency Agency have been negatively impacted by the COVID-19 250 250 crisis, as evidenced by a higher percentage of loans in forbearance. 200 200
150 150 According to the Federal Reserve’s Financial 100 100 Accounts of the United States, as of the second quarter of 2020, outstanding CRE loans totaled 50 50 $4.7 trillion, a 6.6 percent increase year-over- 0 0 year. The total amount of CRE loans outstanding 2004 2006 2008 2010 2012 2014 2016 2018 2020 equates to approximately 24 percent of GDP, YTD Source: Inside Mortgage Finance and has consistently increased since the fourth quarter of 2013, similar to the high reached in the second quarter of 2009. The government agencies, including Fannie Mae, Freddie Mac, and Ginnie Mae (collectively the agencies) continue to be major players in multifamily lending and fund or guarantee about 46 percent of total outstanding multifamily mortgages. CRE loans held by life insurance companies continued to increase, with year-over-year CRE loan growth at insurance companies outpacing that of banks. As of the second quarter of 2020, CRE loans outstanding at U.S. chartered banks were $2.3 trillion (a 5.7 percent increase year- over-year) and the corresponding total for life insurers was $574 billion (a 6.4 percent increase year-over-year). In the Federal Reserve’s July SLOOS, banks reported tightened standards and weaker demand for CRE loans.
Overall CMBS issuance totaling $178 billion through the third quarter of 2020 was roughly flat compared to the same period in 2019. However, agency and non-agency CMBS issuance trends diverged in 2020, with non-agency CMBS issuance declining by 18 percent and agency CMBS issuance increasing by 27 percent year- to-date through September (Chart 3.4.6.3). Non-agency CMBS issuance came to a near halt in the second quarter of 2020, when only $9.5 billion of non-agency CMBS was issued. Non-agency CMBS issuance picked up in the third quarter of 2020, but remained below pre- pandemic levels. Agency CMBS issuance, which is predominantly collateralized by multifamily
Financial Developments 71 properties, experienced modest disruption 3.4.6.4 Commercial Property Price Growth 3.4.6.4 Commercial Property Price Growth in March but issuance resumed subsequently Percent As Of: Sep-2020 Percent in April, benefiting in part from the agency 20 20 guarantee. Agency CMBS issuance accounted for 70 percent of total CMBS issuance in the 10 10 first nine months of 2020 compared to 60
0 0 percent of total CMBS issuance in 2019.
-10 Apartment -10 The emergency actions taken by the Federal Industrial Office Reserve and Treasury have contributed to the -20 -20 Retail stabilization of CMBS market conditions. In National particular, the inclusion of agency CMBS in the -30 -30 2005 2007 2009 2011 2013 2015 2017 2019 Federal Reserve’s direct purchase operation Source: Real Capital Analytics, has supported the return of normal market Bloomberg, L.P. Note: Year-over-year price change. conditions. In addition, the establishment of the Term Asset-Backed Securities Loan Facility (TALF) and inclusion of legacy conduit CMBS in the facility appears to have contributed to 3.4.6.5 Capitalization Rates and Spreads 3.4.6.5 Capitalization Rates and Spreads significant tightening of CMBS spreads, thereby Percent As Of: Sep-2020 Percent improving market conditions. 12 12
10 10 As of September 2020, national CRE prices Average Cap Rate increased by 1.4 percent year-over-year versus 8 8 6.7 percent the previous year. Prices of retail
6 6 and office properties declined for the first time since 2011, while prices of industrial 4 4 and apartment properties held up relatively
2 Average Cap Rate Spread 2 well (Chart 3.4.6.4). There is a high degree of ongoing uncertainty regarding the long- 0 0 2001 2004 2007 2010 2013 2016 2019 term impact on office properties as companies Source: Real Capital Analytics, re-examine office space needs in the post- Bloomberg, L.P. pandemic working environment.
CRE capitalization rates—the ratio of a property’s annual net operating income to its price—remain low by historical standards (Chart 3.4.6.5). However, one measure of the risk premium in CRE—the spread between CRE capitalization rates and the 10-year Treasury yield—increased rapidly in 2020 as the Treasury yield declined by about 125 basis points through September.
According to Real Capital Analytics, the volume of CRE property sales peaked in 2019 at over $550 billion. The strong growth trend was sustained in January and February of 2020. However, the unprecedented speed of the COVID-19-induced economic distress
72 2020 FSOC // Annual Report relative to prior downturns caused a sharp decline in commercial real estate transactions. Transaction volumes declined approximately 40 percent in the first three quarters of 2020 relative to the first three quarters of 2019. The decline in transaction volumes were concentrated in the second and third quarters of 2020, when year-over-year transaction volumes dropped by about 65 percent and 55 percent, respectively. Property types more directly impacted by public health measures in response to the pandemic, such as retail, lodging, and office, experienced larger declines in transaction volumes of 44 percent, 71 percent, and 46 percent, respectively, in the first three quarters of 2020.
Financial Developments 73 Box E: Potential Risks in Commercial Real Estate
The COVID-19 pandemic shock has created supported rent payments for apartments through significant distress for firms and households the summer, mitigating income losses in this sector throughout the economy, leading to reductions in to date. Although widespread work-from-home the cash flows generated by commercial real estate policies have driven an increase in office vacancy (CRE). The shock to CRE has been large, with the rates, tenants in long-term leases are largely making hotel and retail sectors suffering the most significant their rent payments. The hardest-hit properties have near-term losses. Considerable uncertainty remains been in the lodging and retail sectors, as travel has regarding the long-term recovery prospects for a sharply contracted and retail stores have closed due wider range of property types. to stay-at-home orders. Even as parts of the economy Certain features of the current CRE financing have reopened, COVID-19 has resulted in increased environment may raise the potential for spillovers. operational costs for hotel and retail sectors due to Hotel and retail loans are concentrated in non-agency enhanced focus on cleaning, sanitation, and security CMBS; servicing frictions may drive distressed measures. property sales, potentially triggering price declines. Mortgage delinquency rates across sectors tell Additionally, small and mid-sized regional banks are a similar story. Based on survey data from the highly exposed to CRE; losses on CRE loans at these Mortgage Bankers Association, as of August, the banks could drive a broader contraction in credit. share of loans at any stage of delinquency remains Furthermore, potential spillover effects from CRE near pre-pandemic levels for industrial and office lending exposures may be greater in areas that are properties. However, mortgage delinquencies more dependent on local sources of funding. on hotels and retail properties have surged to 23 percent and 15 percent, respectively, and the The Nature of the Shock same survey showed 16 percent and 8 percent of If equity REIT indices are broken out by property respective hotel and retail mortgages in forbearance. type (Chart E.1), the ordering of the price impact As of August, properties on Morningstar’s CMBS is consistent with the pandemic’s impact on cash servicer watchlist, a more forward-looking measure flows by sector. Industrial properties have generally of distress, suggest ongoing stress in the hotel and performed well, as the shift to online retail has retail sectors, with 37 percent and 22 percent of increased demand for warehouses. Fiscal policy loans outstanding on the watchlist compared to 18 measures such as extended unemployment benefits percent and 11 percent in August last year.
E.1 Sector Equity REIT Indices E.1 Sector Equity REIT Indices Percent As Of: 30-Sep-2020 Percent 120 120
100 100
80 80
60 Lodging 60 Retail Office 40 40 Apartment Industrial 20 20
0 0 Jan:2020 Mar:2020 May:2020 Jul:2020 Sep:2020
Source: NAREIT, Bloomberg, L.P. Note: Indexed to February 14, 2020.
74 2020 FSOC // Annual Report Spillover Risks from Stress in CRE CRE lenders may prevent distressed property sales Stress in CRE markets can exacerbate economic during downturns and avoid losses from price declines downturns because CRE debt represents a large either by modifying the terms of delinquent mortgages source of credit exposure for the financial system – or by executing other effective workout plans until about $4.7 trillion as of the second quarter of 2020, CRE markets stabilize. But, institutions vary in their according to data from the Financial Accounts of willingness and ability to take these steps. In general, the United States. Regulations and frameworks banks, life insurance companies, and government regarding capital and liquidity, resolution planning, entities have wide discretion over loans’ terms and and stress testing implemented after the 2008 are more likely to offer mortgage modifications financial crisis have lowered the potential for the than are servicers of non-agency CMBS, which are failure of large, interconnected banks exposed to bound by servicing contracts and who do not directly CRE. Two additional important pathways may cause face losses. Similarly, large banks, large insurance spillovers, however. First, declining cash flows in companies, and government entities may manage the certain CRE sectors could increase distressed timing of property sales to minimize pricing spillovers property sales, which in turn could reduce property better than servicers of non-agency CMBS and smaller values and create price-spirals, though lenders may banks. work with borrowers to prevent distressed sales Financial institutions can also transmit losses on CRE during a market downturn. Second, if lenders accrue loans to the broader economy if they are an important large losses on CRE loans, they could further tighten source of non-CRE credit. This summer, the Federal CRE underwriting standards, potentially hampering Reserve’s stress testing regime for large banks economic growth. included a scenario involving a sharp contraction in The funding mechanism for CRE carries implications the values of retail and lodging properties, and the for how likely spillovers are to materialize. Factors banks had enough capital to maintain the flow of credit influencing spillover risk include institutions’ ability assuming a V-shaped recovery. Several firms, however, to manage losses from CRE and their importance would approach minimum capital ratios under a more as a source of credit. According to data from the severe U or W-shaped scenario, which may result in Financial Accounts of the United States, about half a sustained tightening of underwriting standards or of outstanding CRE mortgages are funded by banks; contraction of credit. Small and mid-sized regional Fannie Mae, Freddie Mac, and other government banks, however, are more highly exposed to CRE than entities fund or guarantee about 17 percent; life the stress-tested banks on average. For example, insurance companies fund about 13 percent; and as of the second quarter of 2020, CRE accounts for about 9 percent are securitized into non-agency about 40 percent of non-CCAR banks’ loan portfolios CMBS. These institutions’ exposure to pandemic- and about 10 percent of CCAR banks’ loan portfolios, driven mortgage distress varies widely. For example, according to bank FR Y9-C or Call Report filings. retail and lodging loans account for about 40 percent These smaller banks are also an important source of of loans securitized into non-agency CMBS; whereas credit to small business and retail borrowers. Sharp they make up only about a quarter of CRE loans losses on CRE-backed loans at small and mid-sized held by large banks and insurance companies. Small banks could drive a broad contraction in credit, and mid-sized regional banks account for over half particularly in the sectors of the economy that rely on of outstanding bank-held CRE loans, but data are local sources of financing. limited on sector-specific exposures.
Box E: Potential Risks in Commercial Real Estate 75 Box E: Potential Risks in Commercial Real Estate
Temporary vs. Permanent Declines in Cash Flows across Sectors Considerable uncertainty remains about which CRE sectors may recover completely following the pandemic and which sectors face permanent shifts in demand. Segments of the retail sector have experienced years of decline as consumers have gradually shifted toward online shopping and away from shopping in physical stores; the pandemic may have accelerated this trend. The changes facing office and apartment properties are likewise unclear. A permanent shift toward teleworking may reduce demand for office space, driving economic activity away from city centers where many apartments, retail, restaurants/food outlets, and offices are located. A permanent shift toward teleworking may also shift demand toward single-family housing and away from apartments. Once the shock fully subsides, however, there may be a reversion to pre- pandemic business practices, in which case recent trends in apartment and office vacancies would likely reverse. Permanent downward changes in cash flows will lead to permanent declines in valuations in certain sectors, and eventually, holders of CRE will realize losses. But, as long as these losses accumulate gradually, they are unlikely to trigger large disruptions to the financial system.
76 2020 FSOC // Annual Report 3.5 Financial Institutions 3.5.1.1 Categorization of Large U.S. BHCs 3.5.1.1 Categorization of Large U.S. BHCs 3.5.1 Bank Holding Companies and Description U.S. Domestic Banking Org.
Depository Institutions Bank of America JPMorgan Chase 3.5.1.1 Bank Holding Companies and Dodd-Frank Category I Bank of New York Mellon Morgan Stanley (U.S. G-SIBs) Citigroup State Street Act Stress Tests Goldman Sachs Wells Fargo BHCs—inclusive of financial holding Category II (Large complex, ≥$700b Total assets, or ≥ Northern Trust companies—are companies registered under $75b in Cross-Jurisdictional Activity) the Bank Holding Company Act that control Category III Capital One Truist Financial (Large complex, ≥$250b Total assets or ≥ $75b Charles Schwab U.S. Bancorp at least one commercial bank. Subsidiaries in NBA, wSTWF, or Off-balance sheet exposure) PNC Financial of BHCs may also include nonbanks such Ally Financial Huntington Category IV American Express KeyCorp as broker-dealers, investment advisers, or (Large noncomplex, other firms with $100b Citizens Financial M&T Bank insurance companies. According to rules to $250b Total assets) Discover Regions Financial Fifth Third Synchrony Financial recently adopted by federal banking agencies to Source: Federal Reserve Note: Northern Trust is in Category II due to its cross-jurisdictional activity. tailor the regulatory framework for enhanced prudential standards and the U.S. Basel III capital and liquidity standards to more closely match the risk profiles of domestic and foreign banks (Tailoring rules), the largest BHCs with total consolidated assets above $100 billion are grouped in four risk-based categories for determining the applicability of regulatory capital and liquidity requirements. Under the final rule, such requirements increase in stringency based on measures of size, cross- jurisdictional activity, weighted short-term wholesale funding, nonbank assets, and off- balance sheet exposures. There are currently eight U.S. global systemically important banks (G-SIBs) (Category I BHCs) and two groups of large BHCs: large complex (Category II and III BHCs) and large noncomplex (Category IV BHCs) (Chart 3.5.1.1). Other BHCs with total consolidated assets less than $100 billion are not subject to the annual stress test exercise or liquidity requirements. Foreign banking organizations (FBOs) with sizeable operations in the United States must hold all non-branch interests in U.S. subsidiaries in an intermediate holding company (IHC).
As of the second quarter of 2020, BHCs in the United States (excluding IHCs) held about $20 trillion in assets. U.S. G-SIBs account for 66 percent of this total. Large complex BHCs account for 10 percent. Large noncomplex BHCs account for 7 percent. All other BHCs account for the remaining 17 percent of assets. The 13 IHCs operating in the U.S.—BBVA,
Financial Developments 77 BMO, BNP Paribas, MUFG, Credit Suisse, 3.5.1.2 Total Assets by BHC Type 3.5.1.2 Total Assets by BHC Type Deutsche Bank, HSBC, TD Group, RBC, Trillions of US$ As Of: 2020 Q2 Trillions of US$ Santander, UBS, Barclays, DWS—have more 14 14 than $2 trillion in consolidated domestic assets 12 12 (Chart 3.5.1.2).
10 10
8 8 Capital Adequacy Equity capital provides a buffer to absorb losses 6 6 from defaulting loans, declines in market 4 4 value of securities and trading portfolios,
2 2 counterparty defaults, and operational and legal risks. Capital adequacy in an economic 0 0 G-SIBs Large Large Other IHCs downturn determines banks’ ability to continue Complex Noncomplex lending and serve as a source of strength to Source: FR Y-9C the rest of the economy. Due to enhanced prudential regulation and robust economic growth, equity capital increased significantly, and the loss-absorbing capacity of the banking 3.5.1.3 Common Equity Tier 1 Ratios 3.5.1.3 Common Equity Tier 1 Ratios sector stood at historically high levels at the end Percent of RWA As Of: 2020 Q2 Percent of RWA of 2019. Following the disruptions in economic 16 16 activity caused by the COVID-19 pandemic, the Other 14 14 strengthened capital positions allowed BHCs Large Noncomplex Large Complex to honor large drawdowns on credit lines and 12 G-SIBs 12 to absorb the significant increases in loan loss 10 10 provisions in anticipation of deteriorating credit
8 8 quality.
6 6 Bank capital adequacy is evaluated using 4 4 risk-based capital requirements and non-risk- 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 based leverage requirements combined with Note: Tier 1 common capital is used as the numerator of the CET1 ratio prior to 2014:Q1 for G-SIBs and large complex BHCs, and prior to Source: FR Y-9C, 2015:Q1 for large noncomplex and other BHCs. The denominator is an annual stress test exercise for Category I-III Haver Analytics risk-weighted assets (RWA). Shaded areas indicate NBER recessions. firms, and biennially for Category IV firms. Common equity tier 1 (CET1) ratio is a risk- based capital requirement, defined as the ratio of CET1 capital to the total risk-weighted assets (RWAs). CET1 ratios decreased for all U.S. G-SIBs as well as for large complex and large noncomplex BHCs in the first quarter of 2020, before rising slightly in the second quarter. The declines in CET1 ratios at U.S. G-SIBs were in large part due to increases in RWAs and to a lesser degree due to contraction in CET1 capital (Chart 3.5.1.3). A primary driver for the increases in RWAs were significant drawdowns on credit lines, which materially increased following the onset of the COVID-19 crisis, that became on-balance sheet commercial and industrial (C&I) loans. This resulted in higher risk-weighted assets than an undrawn off-
78 2020 FSOC // Annual Report balance sheet credit line commitment. Market 3.5.1.4 Common Equity Tier 1 Ratios at U.S. G-SIBs volatility, particularly for trading portfolios, also 3.5.1.4 Common Equity Tier 1 Ratios at U.S. G-SIBs contributed to the increase in RWAs. CET1 ratios Percent of RWA As Of: 2020 Q2 Percent of RWA rose for the U.S. G-SIBs in the second quarter 20 20 2020 Q2 Minimum including U.S. G-SIB as RWA fell on commercial credit line paydowns 2020 Q1 surcharge (2020) 2019 Q2 and reductions in credit card balances. 16 16
12 12 On net, risk-based regulatory capital ratios declined in the first half of 2020. However, U.S. 8 8 G-SIBs continue to meet Basel III standards for the minimum risk-based weighted capital 4 4 requirement ratios including the G-SIB surcharge and capital conservation buffer (Chart 0 0 3.5.1.4). Furthermore, U.S. G-SIBs as well as JPM C MS BAC GS WFC BK STT Source: FR-Y9C other large or small BHCs maintained sizeable voluntary capital buffers above minimum requirements, allowing those banks to continue to lend. The Federal regulatory banking agencies issued a joint statement in March 2020 encouraging banks and other regulated lenders to use their available capital and liquidity to continue to provide credit to consumers and small businesses affected by COVID-19.
In March 2020, the Federal Reserve adopted the stress capital buffer (SCB) rule that came into effect for the 2020 stress test cycle. The SCB rule simplified the Board’s capital framework by integrating non-stress and stress-based capital requirements with the introduction of the SCB requirement. In particular, the SCB replaced the static 2.5 percent capital conservation buffer with an SCB requirement. The SCB requirement is floored at a minimum of 2.5 percent of risk-weighted assets and is calculated as the difference between starting and minimum projected CET1 capital ratios under the severely adverse scenario in the supervisory stress test, plus four quarters of planned common stock dividends as a percentage of risk-weighted assets. The final SCB rule did not include a stress leverage buffer requirement. A BHC or IHC subject to the rule whose regulatory capital ratios are at or below its regulatory minimum plus its SCB requirements, any applicable G-SIB surcharge, or countercyclical capital buffer, would be subject to automatic restrictions on capital distributions and certain discretionary bonus payments.
Financial Developments 79 3.5.1.5 Payout Rates at U.S. G-SIBs The overall payout rates at U.S. G-SIBs, defined 3.5.1.5 Payout Rates at U.S. G-SIBs as the sum of stock repurchases and common Percent of NIAC As Of: 2020 Q2 Billions of US$ stock dividends, were close to 100 percent of 175 140 NIAC (right axis) the net income available to common equity in 150 Common Stock Cash Dividends (left axis) 120 2018 and exceeded 100 percent in 2019. Payouts Stock Repurchases (left axis) 125 100 to shareholders fell slightly in the first quarter 100 80 of 2020 compared to the 2019 historic highs
75 60 (Chart 3.5.1.5). However, net income available to common shareholders fell sharply in the 50 40 first quarter of 2020, and, subsequently, payout 25 20 rates were substantially above 100 percent of 0 0 net income. At the beginning of the COVID-19 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 crisis, all U.S. G-SIBs announced voluntary Note: Payout rates are the ratios of stock repurchases plus cash dividends to net income available to common shareholders (NIAC). NIAC is net income suspension of share buybacks through at least Source: FR Y-9C minus preferred dividends. 2020 data represents YTD data through Q2. the first half of 2020. Following the release of stress test results in June 2020, the Federal Reserve temporarily halted stock repurchases and capped dividends payments for all BHCs. 3.5.1.6 Supplementary Leverage Ratios at U.S. G-SIBs 3.5.1.6 Supplementary Leverage Ratios at U.S. G-SIBs As a result, firms made dividend payments Percent As Of: 2020 Q2 Percent based on a formula tied to recent net income. 20 20 2020 Q2 (non-modified) 2020 Q2 (modified) 2019 Q4 The supplementary leverage ratio (SLR) is 15 15 Minimum a non-risk-based capital adequacy measure defined as the ratio of tier 1 capital to 10 10 total assets, plus certain off-balance sheet exposures. The SLR applies to large complex 5 5 BHCs and an enhanced version of the SLR applies to U.S. G-SIBs. Since the start of the 0 0 COVID-19 pandemic, the depository institution JPM BAC STT WFC C MS GS BK subsidiaries of BHCs have experienced large Note: Enhanced supplementary leverage ratio is only required for the G-SIBs. Source: FR Y-9C, The ratio for 2019 Q4 is equal to tier 1 capital divided by total assets plus off- balance sheet exposures. The modified ratio for 2020 Q2 is equal to tier 1 inflows of deposits and significant balance Call Report capital divided by total assets minus Treasury securities and reserves. sheet expansion that reduced leverage ratios of BHCs. In addition, borrowers’ drawdowns on credit lines contributed to further balance sheet increases and reductions in leverage ratios. The Federal Reserve, FDIC, and OCC introduced a temporary modification to the SLR rule that allows BHCs to exclude Treasury securities and reserves at the Federal Reserve from the denominator of the ratio until March 31, 2021. Those temporary modifications provide flexibility to certain banks to continue to expand their balance sheets and provide credit to households and businesses. The enhanced SLRs under the temporary rule increased substantially for some U.S. G-SIBs (Chart 3.5.1.6).
80 2020 FSOC // Annual Report Profitability 3.5.1.7 Return on Assets Bank profitability as measured by return 3.5.1.7 Return on Assets on assets fell sharply across the four BHC Percent As Of: 2020 Q2 Percent 3 3 categories in the first half of 2020 and for some Other BHCs net income became negative (Chart Large Noncomplex 2 Large Complex 2 3.5.1.7). This contraction in profitability G-SIBs was mostly driven by increases in loan loss provisions and to a lesser degree by declines 1 1 in other components of net income. In particular, banks with significant credit card 0 0 loan portfolios experienced large increases in loan loss provisions—following the change -1 -1 to Current Expected Credit Losses (CECL) 2010 2012 2014 2016 2018 2020 accounting and deteriorating economic Note: Quarterly, seasonally-adjusted annual rate. Return on Source: FR Y-9C assets is equal to net income divided by average assets. conditions—and reported large contractions in net incomes in the first half of 2020. Other components of net income, such as net interest margins (NIMs), declined across all four BHC 3.5.1.8 Net Interest Margins groups that file FR Y-9Cs (Chart 3.5.1.8). 3.5.1.8 Net Interest Margins Percent As Of: 2020 Q2 Percent 6 6 Funding Sources Other During and prior to the 2008 financial crisis, Large Noncomplex 5 5 BHCs relied heavily on short-term wholesale Large Complex G-SIBs funding, and disruptions in interbank markets 4 4 exposed BHCs to significant liquidity and solvency risks. Since then, the ratio of such 3 3 unstable funding to total assets has declined 2 2 substantially below its 2007 level. At the same time, BHCs attracted large inflows of 1 1 more stable sources of funding such as core 2010 2012 2014 2016 2018 2020 Note: Quarterly, seasonally-adjusted annual rate. Net deposits. BHCs also maintained a steady share interest margin is equal to net interest income divided of long-term debt in recent years, including Source: FR Y-9C by the quarterly average of interest-earning assets. at U.S. G-SIBs, for purposes of meeting the minimum long-term debt requirement under TLAC (Chart 3.5.1.9). As a result of this more stable funding mix, BHCs did not experience 3.5.1.9 Selected Sources of Funding at U.S. G-SIBs 3.5.1.9 Sources of Funding at G-SIBs and Large-Complex significant disruptions in their funding during Percent of Total Liabilities As Of: 2020 Q2 Percent of Total Liabilities the COVID-19 crisis. Furthermore, the Federal 70 70 Reserve established a number of credit and 60 60 Short-Term Funding Core Deposits liquidity facilities that helped stabilize STFMs. 50 50
40 40
30 30
20 20 Long-Term Funding 10 10
0 0 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
Note: ST funding: liabilities with maturities =< 1 yr, trading liabilities, repos, CP, and foreign deposits. Source: LT funding: other borrowed money, subordinated notes and large time deposits with maturities > 1 yr. Core deposits: demand deposits, noninterest-bearing balances, transaction FR Y-9C accounts, money market deposits and time deposits <$250,000.Gray bars signify NBER recessions.
Financial Developments 81 3.5.1.10 Deposit Growth, All Commercial Banks The unfolding of the COVID-19 pandemic 3.5.1.10 Deposit Growth, All Commercial Banks triggered flight-to-safety dynamics that led to Percent As Of: Sep-2020 Percent increases in bank deposits, while other sources 25 25 of funding remained mostly stable (Chart
20 20 3.5.1.10). A significant share of deposit inflows was also due to corporations drawing on their 15 15 bank credit lines and depositing the proceeds with banks, as well as payments from fiscal 10 10 programs.
5 5 Following the normalization of monetary 0 0 policy in December 2015, effective deposit rates 2001 2004 2007 2010 2013 2016 2019 gradually increased through 2019 with the rise Note: Statistical Release H.8, “Assets and Liabilities of Source: Federal Reserve, Commercial Banks in the United States.” Seasonally adjusted in federal funds rates. The interest rate cuts in Haver Analytics values. Year-over-year percentage change. 2019 and the more recent return of the federal funds rate to its effective lower bound resulted in deposit rates nearly falling back to their 2015 levels (Chart 3.5.1.11). 3.5.1.11 Effective Deposit Rates by BHC Category 3.5.1.11 Effective Deposit Rates by BHC Category Rates As Of: 2020 Q2 Rates Asset Quality 1.50 1.50 Overall delinquency rates remained low and Other 1.25 Large Noncomplex 1.25 stable in 2019, in part due to low delinquency Large Complex rates for real estate loans (Chart 3.5.1.12). 1.00 1.00 G-SIBs Mortgage lending following the 2008 0.75 0.75 financial crisis has been predominantly to households with prime credit scores and 0.50 0.50 lenders have applied significantly more 0.25 0.25 conservative underwriting standards. In
0.00 0.00 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Note: Effective deposit rates are defined as the ratio of the annualized quarterly-average interest expense on deposits and the one-quarter lag Source: Call Report of the quarterly-average deposit balances.
3.5.1.12 Delinquency Rates on Real Estate Loans 3.5.1.12 Delinquency Rates on Real Estate Loans Percent As Of: 2020 Q2 Percent 20 20
16 16 Residential 12 Real Estate 12 Commercial 8 Real Estate 8
4 4
0 0 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Note: Includes all loans in domestic and foreign Source: FR Y-9C offices. Gray bars signify NBER recessions.
82 2020 FSOC // Annual Report contrast, delinquency rates for consumer loans 3.5.1.13 Delinquency Rates on Selected Loans such as credit cards and auto loans increased 3.5.1.13 Delinquency Rates on Selected Loans slightly in 2019, consistent with higher shares Percent As Of: 2020 Q2 Percent of originations to subprime borrowers (Chart 8 8 3.5.1.13). 6 Credit Card 6 Auto The adverse effects of the COVID-19 pandemic C&I on economic activity resulted in significant 4 4 deterioration of liquidity positions and debt servicing capacity of household and business 2 2 borrowers, leading to a reassessment of credit policies by banks. In the responses to the July 0 0 2020 SLOOS, banks indicated on balance that 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Note: Seasonally adjusted. Includes all loans in domestic the levels of underwriting standards for most Source: FRY-9C, and foreign offices. Auto loans became available in 2011 Call Report Q1. Gray bars signify NBER recessions. loan categories were relatively tighter than the mid-points of the ranges of those standards since 2005. Banks reported weaker demand for all commercial loan categories, and stronger 3.5.1.14 Provisions to Loans Ratios at BHCs demand for all residential real estate loans 3.5.1.14 Provisions to Loans Ratios at BHCs categories. Percent As Of: 2020 Q2 Percent 12 12 Credit Cards Despite disruptions in economic activity 10 Other Consumer 10 caused by the pandemic, delinquency rates Residential Real Estate in the first two quarters of 2020 did not 8 Commercial Real Estate 8 C&I increase substantially from their existing 6 6 trends. Loan forbearance programs, along with government stimulus and deferred tax 4 4 payments, contributed to better-than-expected 2 2 credit performance in the first two quarters of 0 0 2020. Mortgage forbearance programs provided 2013 2014 2015 2016 2017 2018 2019 2020 household borrowers with greater liquidity and increased capacity to pay down other debt such Source: FR Y-9C Note: Excludes Barclays, Credit Suisse, DB, and UBS. as credit cards and auto loans. However, BHCs significantly increased their loan loss provisions in the first half of 2020 (Chart 3.5.1.14).
The introduction of the CECL accounting standard has, for those institutions that have implemented CECL, changed how these institutions provision for loan losses, from using incurred losses under the previous accounting standard to estimating losses over the financial asset’s contractual term adjusted for prepayments. Because the adoption of CECL could lead to one-time reductions in regulatory capital ratios, banks were given the option to phase in the regulatory capital effects of the updated accounting standard over a period of three years. In addition, the
Financial Developments 83 supervisory stress test modeling framework 3.5.1.15 C&I Loan Growth, All Commercial Banks 3.5.1.15 C&I Loan Growth, All Commercial Banks as it relates to projecting loan allowances and Percent As Of: Sep-2020 Percent provisions would not be revised to account for 40 40 CECL in the 2020 and 2021 cycles. To allow 30 30 banking organizations to better focus on 20 20 supporting lending to creditworthy households
10 10 and businesses in light of recent strains on the U.S. economy as a result of COVID-19, while 0 0 also maintaining the quality of regulatory -10 -10 capital, the federal banking regulators issued -20 -20 a final rule on August 26, 2020, that allowed -30 -30 the option to delay for two years an estimate 2001 2004 2007 2010 2013 2016 2019 of CECL’s effect on regulatory capital, relative Note: Statistical Release H.8, “Assets and Liabilities Source: Federal Reserve, of Commercial Banks in the United States.” Year- to the incurred loss methodology’s effect on Haver Analytics over-year percentage change. regulatory capital, followed by a three-year transition period.
Corporate borrowers, especially in industries 3.5.1.16 Loans to Nondepository Financial Institutions 3.5.1.16 Loans to Nondepository Financial Institutions directly impacted by the pandemic, drew Percent of Total Loans As Of: 2020 Q2 Percent of Total Loans their credit lines to meet current—and hedge 12 12 against future—liquidity and funding needs. Other 10 Large Noncomplex 10 The drawdowns on credit lines resulted in Large Complex significant increases in outstanding C&I loans. 8 G-SIBs 8 In addition, PPP loans outstanding, which were
6 6 mostly C&I loans and amounted to $484 billion as of June 30, drove this increase. The average 4 4 year-over-year growth of C&I loans exceeded 20
2 2 percent from April through July 2020 (Chart 3.5.1.15). 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Lending to nondepository financial institutions Source: FR Y-9C has increased since 2010, significantly outpacing the growth rates in commercial loans to nonfinancial firms. The growth in loans to nonbank financials accelerated notably at the 3.5.1.17 High-Quality Liquid Assets by BHC Type end of 2019 and in the first quarter of 2020. A 3.5.1.17 High-Quality Liquid Assets by BHC Type Percent of Assets As Of: 2020 Q2 Percent of Assets large part of the increase in the first quarter 30 30 of 2020 was due to drawdowns of credit lines Other Large Noncomplex that were subsequently paid down in the second 25 Large Complex 25 quarter of 2020 (Chart 3.5.1.16). G-SIB 20 20 Liquidity Management 15 15 In 2019, all BHCs subject to the liquidity coverage ratio (LCR) reduced their holdings 10 10 of high-quality liquid assets (HQLA) and, in particular, their reserves (Chart 3.5.1.17). 5 5 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 HQLA began to increase in the last quarter Note: HQLA is estimated by adding excess reserves to an of 2019 mostly due to increases in reserves estimate of securities that qualify for HQLA. Haircuts and Source: FR Y-9C level 2 asset limitations are incorporated into the estimate. following interventions of the Federal
84 2020 FSOC // Annual Report Reserve in repo markets in September 3.5.1.18 Selected Liquid Assets at All BHCs 2019. The increase in reserves significantly 3.5.1.18 Selected Liquid Assets at All BHCs accelerated with the influx of deposits and the Percent of Assets As Of: 2020 Q2 Percent of Assets establishment of the asset purchase programs 12 12 Reserve Balances by the Federal Reserve in the first half of 2020 10 Fannie Mae and Freddie Mac MBS 10 (Chart 3.5.1.18). Treasury Securities Ginnie Mae MBS 8 8
Deposit inflows and inflows of more stable 6 6 insured retail deposits helped alleviate liquidity pressures from the large credit line drawdowns. 4 4
U.S. G-SIBs continued to maintain liquidity 2 2 ratios well above the 100 percent requirement in 0 0 the first two quarters of 2020 (Chart 3.5.1.19). 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 LCR ratios rose for six of the eight U.S. G-SIBs Source: FR Y-9C, FR 2900 Note: Quarterly, NSA. in the second quarter of 2020. The Tailoring rules exempted BHCs with total consolidated assets below $100 billion from the LCR and reduced LCR requirements for Categories III 3.5.1.19 Liquidity Coverage Ratios at U.S. G-SIBs and IV, based on their reliance on short-term 3.5.1.19 Liquidity Coverage Ratios at U.S. G-SIBs wholesale funding. Percent As Of: 2020 Q2 Percent 200 200 2020 Q2 There was a large shift of held-to-maturity 2020 Q1 2019 Q4 investment securities to available-for-sale 150 150 status at the end of 2019, which reflected re-optimization by banks after the Tailoring 100 100 rules went into effect on December 31, 2019.
The rules allowed large complex and large 50 50 noncomplex BHCs to opt-out of including accumulated other comprehensive income 0 0 from available-for-sale accounts in their capital JPM C MS BAC GS WFC BK STT calculation. Most large complex and some large Source: LCR Disclosures Note: The solid line represents the noncomplex BHCs shifted their entire holdings from each banks’ websites regulatory minimum. of securities from held-to-maturity into available-for-sale accounts (Chart 3.5.1.20).
The duration gap between the timing of cash 3.5.1.20 Held-to-Maturity Securities 3.5.1.20 Held-to-Maturity Securities inflows from assets and the timing of cash Percent of Investment Percent of Investment outflows from liabilities at U.S. G-SIBs and Securities As Of: 2020 Q2 Securities 40 40 large BHCs remained on balance unchanged in Other 2020, whereas the duration gap at other BHCs Large Noncomplex 30 Large Complex 30 increased slightly. Duration gaps are measures G-SIB of interest rate risk at BHCs. The flattening 20 20 of the yield curve and expectations for lower interest rates are likely to negatively impact 10 10 profitability and capital at BHCs with smaller duration gaps (Chart 3.5.1.21). 0 0 1997 2001 2005 2009 2013 2017 Note: Investment securities are held-to-maturity Source: Call Report, securities plus available-for-sale securities. Gray Haver Analytics bars signify NBER recessions.
Financial Developments 85 3.5.1.21 Duration Gap Market Perception of Value and Risk 3.5.1.21 Duration Gap Investor expectations for significantly lower Years As Of: 2020 Q2 Years bank profitability were reflected in sharp 3.5 3.5 Other declines in bank stock valuations and market 3.0 Large Noncomplex 3.0 Large Complex capitalization in March 2020. Even though bank 2.5 G-SIBs 2.5 stock prices partially recovered in April through 2.0 2.0 June 2020, bank stocks performed notably worse than the S&P 500 stock index (Chart 1.5 1.5 3.5.1.22). 1.0 1.0
0.5 0.5 Price-to-book ratios of the U.S. G-SIBs followed 0.0 0.0 similar patterns to their stock performance. 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Despite the partial recovery of market Note: Duration gap is the approximate weighted-average Source: Call Report, time of cash inflows less the approximate weighted-average valuations, most U.S. G-SIBs’ price-to-book Haver Analytics time of cash outflows. Gray bars signify NBER recessions. ratios remained below or around 100 as of June 2020. Low market-based capital and price-to- book ratios limit BHCs’ ability to raise equity capital externally (Chart 3.5.1.23). 3.5.1.22 Bank Stock Performance 3.5.1.22 Bank Stock Performance Index As Of: 29-Jun-2020 Index 175 175 Large Noncomplex S&P 500 Large Complex EU Bank Stock Index 150 150 G-SIBs Other
125 125
100 100
75 75
50 50 Jan:2019 Apr:2019 Aug:2019 Dec:2019 Apr:2020
Note: January 2, 2019 = 100. EU Bank Stock Index created from Source: Yahoo Finance!, stock prices for the following banks: BCS, BNPQY, CS, ACA, DB, Bloomberg, L.P. SAN, UBS. All indexes are created by equally weighting banks.
3.5.1.23 Price-to-Book of Select U.S. G-SIBs 3.5.1.23 Price-to-Book for Select U.S. G-SIBs Percent As Of: Jun-2020 Percent 300 300 Goldman Sachs Wells Fargo 250 Citigroup JPMorgan Chase 250 Bank of America Morgan Stanley 200 200
150 150
100 100
50 50
0 0 2008 2010 2012 2014 2016 2018 2020
Source: SNL Note: Month-end values.
86 2020 FSOC // Annual Report CDS spreads of U.S. G-SIBs, a measure of 3.5.1.24 5-Year CDS Premiums of Select U.S. G-SIBs default risk, increased notably in the spring 3.5.1.24 5-Year CDS Premiums Select U.S. G-SIBs but have since tightened. Some U.S. G-SIBs’ Basis Points As Of: Jun-2020 Basis Points 500 500 CDS spreads rose by more than 100 basis Goldman Sachs Wells Fargo points, exceeding the increases in CDS spreads 400 Citigroup JPMorgan Chase 400 observed in February 2016 when markets were Bank of America Morgan Stanley concerned about a global economic slowdown 300 300 and the possibility of a low-for-long interest rate environment. Nonetheless, the increases in CDS 200 200 spreads in 2020 were significantly smaller than those observed during the 2008 financial crisis. 100 100 In large part, the lower CDS spreads at the 0 0 onset of the COVID-19 crisis reflect the much 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 better liquidity and capital positions of BHCs Source: Markit Note: Monthly averages. (Chart 3.5.1.24). CDS spreads of foreign G-SIBs performed similarly to U.S. G-SIBs with the exception of Deutsche Bank, which experienced the largest increase in CDS spreads among 3.5.1.25 5-Year CDS Premiums of Select Foreign Banks foreign G-SIBs, exceeding 200 basis points 3.5.1.25 5-Year CDS Premiums Select Foreign Banks (Chart 3.5.1.25). Basis Points As Of: Jun-2020 Basis Points 500 500 Deutsche Bank RBS Dodd-Frank Act Stress Tests and the Société Générale Santander 400 Credit Suisse Barclays 400 Assessment of Bank Capital during BNP Paribas
COVID-19 Event 300 300
The CCAR is an annual exercise by the Federal 200 200 Reserve to assess whether the largest BHCs operating in the United States have sufficient 100 100 capital to continue operations throughout times of economic and financial stress and that they 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 have robust, forward-looking capital-planning Note: Monthly averages. processes that account for their unique risks. Source: Markit
As part of this exercise, the Federal Reserve evaluates institutions’ capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions, such as dividend payments or stock repurchases. Dodd-Frank Act stress testing (DFAST)—a complementary exercise to CCAR—is a forward-looking exercise that evaluates the capital adequacy of BHCs and IHCs to absorb losses over a nine-quarter period resulting from stressful economic and financial market conditions in hypothetical supervisory scenarios. The stress test is conducted by the Federal Reserve and the supervisory stress scenarios are designed by the Federal Reserve. The Federal Reserve consults
Financial Developments 87 with the FDIC and OCC on the scenarios, which 3.5.1.26 Initial and Stressed Capital Ratios 3.5.1.26 Initial and Stressed Capital Ratios are also used for company-run stress tests by Percent of RWA Percent of RWA national banks, state nonmember banks, and 16 16 Pre-Stress Post-Stress CCAR federal savings associations. As part of DFAST, Post-Stress DFAST Regulatory Minimum the firms must report their company-run stress 12 12 test results to the Federal Reserve, their primary regulator, and the public. 8 8
In the 2020 stress test cycle, 34 BHCs and IHCs 4 4 were stress tested. The aggregate CET1 ratio would decline from 12 percent in the fourth 0 0 2013 2014 2015 2016 2017 2018 2019 2020 quarter of 2019 to its minimum of 9.9 percent 18 30 31 33 34 35 18 33 Note: Regulatory minimum is 5% pre-2016 and 4.5% from 2016 as part of the severely adverse scenario. The Source: Federal onwards. For DFAST 2013-2015, bars show Tier 1 Common Capital Ratio. DFAST 2016-2020 bars show Common Equity Tier 1 Ratio. The DFAST 2020 results were broadly similar to Reserve x-axis labels represent the number of banks tested within a given year. those of prior year exercises (Chart 3.5.1.26). In particular, aggregate loan losses as a percentage of the average loan balances in the severely adverse scenario in DFAST 2020 were comparable to the past several years. Finally, the Board did not object to the five IHCs (Barclays, Credit Suisse, Deutsche Bank, DWS, and UBS), whose capital planning practices were subject to qualitative assessment as part of the stress test.
In June 2020, the Federal Reserve announced that it had conducted a sensitivity analysis of bank capital adequacy taking into account the significant economic uncertainty during the COVID-19 pandemic. The Federal Reserve constructed three alternative downside scenarios to model possible paths for the economy: a rapid V-shaped recession and recovery, a slower U-shaped recession and recovery, and a W-shaped double-dip recession with a short-lived interim recovery. All three alternative downside scenarios featured higher peak unemployment rates and larger declines in GDP than the severely adverse scenario. Furthermore, the sensitivity analysis did not take into account the mitigating effects of government stimulus programs and expanded unemployment insurance.
The results of the sensitivity analysis showed that aggregate loan losses ranged from $560 billion to $700 billion. Most firms remained well-capitalized and aggregate capital ratios declined from 12.0 percent in the fourth quarter of 2019 to minimum values between
88 2020 FSOC // Annual Report 9.5 percent and 7.7 percent across the three 3.5.1.27 Minimum CET1 Capital Ratios in the Severely Adverse alternative scenarios. However, several firms 3.5.1.27 andMinimum Alternative CET1 Downside Capital ScenariosRatios in the Severely would approach minimum capital requirements Adverse and Alternative Downside Scenarios (Chart 3.5.1.27). Minimum CET1 Capital Ratio Scenario 25th 75th Aggregate Percentile Percentile The Federal Reserve took several actions to preserve the resilience of the banking system Stress Test in light of significant economic uncertainty Severely Adverse 8 12.3 9.9 during the pandemic. The Federal Reserve required CCAR applicable banks to temporarily Sensitivity Analysis suspend share repurchases and limit dividend V-shaped 7.5 11.3 9.5 payments based on recent earnings. In U-shaped 5.5 10.8 8.1 addition, the Federal Reserve required large W-shaped 4.8 10.5 7.7 banks to re-evaluate and resubmit their long- Note: Excludes common distributions. Sample consists Source: Federal Reserve of the 33 firms participating in DFAST 2020. term capital plans in early November. Results from the CCAR 2020 resubmission and further policy actions, if any, will be disclosed by year-end 2020. On September 17, 2020, the 3.5.1.28 FDIC-Insured Failed Institutions Board released two scenarios featuring severe 3.5.1.28 FDIC-Insured Failed Institutions recessions for a second round of bank stress Number of Institutions As Of: 2019 Percent tests that would reassess banks’ resiliency in 600 5 the face of the continued uncertainty from the 500 Number of Assets of Failed 4 COVID-19 pandemic. The Board will release Institutions Institutions as a Percent firm-specific results from banks’ performance 400 (left axis) of Nominal GDP (right axis) 3 under these scenarios by the end of the year. 300 2 3.5.1.2 Insured Commercial Banks and Savings 200 1 Institutions 100 As of the second quarter of 2020, the banking 0 0 industry included 5,066 FDIC-insured 1980 1985 1990 1995 2000 2005 2010 2015 commercial banks and savings institutions with Source: BEA, FDIC, Note: No FDIC-insured institutions total assets of $21.1 trillion. There were 1,010 Haver Analytics failed during 2005, 2006, and 2018. institutions with assets under $100 million and 903 institutions with assets over $1 billion. During 2019, 226 institutions were absorbed by mergers, while 13 new charters were added. Failures of insured depository institutions are down significantly since the 2008 financial crisis; four institutions failed in 2019 and four had failed at the time of this report in 2020 (Chart 3.5.1.28).
As of year-end 2019, the FDIC’s “problem bank” list included 51 institutions—1 percent of all institutions—in comparison to 60 banks the prior year. Banks on this list have financial, operational, or managerial weaknesses that require corrective action in order to operate in a safe and sound manner.
Financial Developments 89 3.5.1.29 Commercial Bank and Thrift Net Income The total assets of U.S. commercial banks 3.5.1.29 Commercial Bank and Thrift Net Income and savings institutions increased by $2.9 Billions of US$ As Of: 2020 Q2 Billions of US$ trillion between the second quarter of 2019 1500 1500 Non-interest Income Realized Gains/Losses and the second quarter of 2020. Loans and Net Interest Income Net Income 1000 1000 leases increased by $695 billion during that period. While all major loan categories grew, 500 500 C&I increased the most, up $473 billion or 0 0 21 percent. Growth in the C&I portfolio was driven by a combination of draws on lines of -500 -500 credit by businesses and PPP lending. Banks -1000 Provisions Income Tax Expense -1000 increased their investment securities by $737 Noninterest Expense billion since the second quarter of 2019, with -1500 -1500 2009 2011 2013 2015 2017 2019 U.S. Treasury securities balances up by 51 Note: Includes all FDIC-insured commercial percent and MBS up by 16 percent. Cash and Source: FDIC banks and thrifts. Values are annualized. due from accounts also grew $1.3 trillion or 78 percent, driven by a large inflow of deposits, and now represent 14 percent of total assets, up from 9 percent a year ago.
For the first six months of 2020, net income for all U.S. commercial banks and savings institutions totaled $37 billion, a 70 percent decline from the first six months of 2019, driven by a decline in net interest income and rise in loan loss provisions (Chart 3.5.1.29). Net interest income fell by 3.5 percent in the first half of 2020 due to interest income declines outpacing interest expense declines. Interest- earning assets grew 17 percent since June 2019; however, the yields on these assets do not compensate for the 150 basis point drop in rates in early 2020. These earnings trends were broad-based throughout the industry, as more than half of commercial banks and savings institutions reported lower earnings in the first half of 2020.
Credit quality has begun to show modest deterioration. The noncurrent ratio rose 15 basis points from the second quarter of 2019 to 1.08 percent of total loans. Loan loss provisions for the first six months of 2020 rose $88 billion, reflecting economic conditions and the implementation of the CECL accounting standard.
The long-term trend of banking industry consolidation continued in 2019 and 2020, as the ten largest institutions continued to hold over 50 percent of total industry assets (Chart
90 2020 FSOC // Annual Report 3.5.1.30). The 100 largest institutions hold 3.5.1.30 Total Assets of Largest Insured Depository Institutions about 82 percent of total industry assets, which 3.5.1.30 Total Assets of Largest Insured Depository Institutions is a historical high. As of the second quarter of Trillions of US$ As Of: 2020 Q2 Count (‘000s) 2020, the total number of banks and savings 25 25 Top 10 IDIs (left axis) Number of Insured associations decreased to 5,066, which is a Top 100 IDIs (left axis) Depository Institutions 20 20 historical low. Other IDIs (left axis) (right axis)
15 15 3.5.1.3 U.S. Branches and Agencies of Foreign Banks 10 10 As of June 30, 2020, assets of U.S. branches and 5 5 agencies of foreign banks totaled $2.6 trillion, up nearly six percent from June 30, 2019 (Chart 0 0 3.5.1.31). Reserve balances for U.S. branches 1984 1989 1994 1999 2004 2009 2014 2019 and agencies of foreign banks totaled $640.1 Note: Fourth quarter data was used for years 1984 - Source: FFIEC Call Report 2019 and second quarter data was used for 2020. billion, comprising 25 percent of total assets as of June 30, 2020. Reserve balances increased 24 percent year-over-year and accounted for 90 percent of asset growth during the same 3.5.1.31 U.S. Branches and Agencies of Foreign Banks: Assets timeframe. Noted growth in reserve balances 3.5.1.31 U.S. Branches and Agencies of Foreign Banks: Assets is largely attributed to increased borrowings Trillions of US$ As Of: 2020 Q2 Trillions of US$ 4 4 from head offices and related entities of U.S. Securities Purchased with Repos & Other Assets Fed Funds Sold Non-C&I Loans branches and agencies of foreign banks that Net Due from Related Institutions C&I Loans were placed on deposit at the Federal Reserve. 3 Reserve Balances 3 Cash and Balances Due from In addition, deposits of borrowings from the Depository Institutions (Excluding Reserve Balances) Discount Window and certain Federal Reserve- 2 2 sponsored liquidity facilities contributed to the increase in reserve balances and the 1 1 maintenance of excess liquidity at U.S. branches and agencies of foreign banks. 0 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 Securities purchased under agreement to Source: Federal Reserve, Note: Other assets includes government resell (reverse repos) and fed funds sold at Haver Analytics securities, ABS, and other trading assets. U.S. branches and agencies of foreign banks decreased by $79 billion or 21 percent from June 30, 2019, to June 30, 2020. Reverse repos represented 12 percent of total assets at U.S. branches and agencies of foreign banks as of June 30, 2020, compared to nearly 16 percent of total assets one year prior. The contraction in reverse repos is consistent with reduced market activity at the point of severe stress toward the beginning of the outbreak and with the intent of U.S. branches and agencies of foreign banks to preserve liquidity at the onset of the pandemic.
As of June 30, 2020, total loan balances accounted for approximately 34 percent of total assets at U.S. branches and agencies of foreign banks. C&I lending remained a significant
Financial Developments 91 portion of overall lending by U.S. branches and 3.5.1.32 U.S. Branches and Agencies of Foreign Banks: Liabilities 3.5.1.32 U.S. Branches and Agencies of Foreign Banks: Liabilities agencies of foreign banks, with a ratio of C&I Trillions of US$ As Of: 2020 Q2 Trillions of US$ loans to total loans of approximately 56 percent 4 4 Other Liabilities as of June 30, 2020. C&I loan levels rose $78 Securities Sold with Repos & Fed Funds Purchased billion or 19 percent between June 30, 2019 and Deposits & Credit Balances 3 3 Net Due to Related Depository Institutions June 30, 2020. The most significant increases in C&I loans occurred during the first quarter of 2 2 2020, driven by corporate draws on revolving and committed lines of credit.
1 1 Deposits and credit balances represented 45
0 0 percent of total liabilities for U.S. branches 2004 2006 2008 2010 2012 2014 2016 2018 2020 and agencies of foreign banks as of June 30, Source: Federal Reserve, Note: Other liabilities includes transaction accounts, 2020 (Chart 3.5.1.32). Net due to related Haver Analytics non-transaction accounts, and other borrowed money. depository institutions increased $60 billion or 14 percent from June 30, 2019 to June 30, 2020. The year-over-year increase in net due to related depository institutions was driven by an uptick in head office borrowings from the Federal Reserve’s liquidity swap lines in the first quarter, which returned to more normal levels by the end of the second quarter. This funding was generally downstreamed to U.S. branches and agencies of foreign banks to support local operations and meet dollar liquidity needs. Securities sold with repurchase agreements (repos) and federal funds purchased decreased $10 billion or two percent between June 30, 2019, and June 30, 2020. Repos totaled 35 percent of total liabilities for U.S. branches and agencies of foreign banks as of June 30, 2020, and decreased two percent year-over-year. While this figure initially increased in the first quarter given enhanced participation in the Federal Reserve’s emergency lending facilities, particularly with the expansion of the repo facility, it has since fallen.
3.5.1.4 Credit Unions Credit unions are member-owned, not-for- profit, depository institutions. As of the second quarter of 2020, there were 5,164 federally insured credit unions with aggregate assets of $1.75 trillion. Just over two-thirds of credit unions (3,476) had assets under $100 million, with 24 percent having less than $10 million in assets. There were 1,331 credit unions with assets between $100 million and $1 billion, and 357 credit unions with assets over $1 billion.
92 2020 FSOC // Annual Report Consistent with long-running trends among 3.5.1.33 Credit Union Income depository institutions, consolidation in the 3.5.1.33 Credit Union Income credit union industry has continued recently, Billions of US$ As Of: 2020 Q2 Billions of US$ 100 100 particularly at smaller institutions. The number Noninterest Income Net Income Net Interest Income of credit unions with less than $50 million in assets fell to 2,811 in the second quarter of 50 50 2020, bringing the cumulative decline over the past five years to 28 percent. At the same time, 0 0 however, total industry assets have grown at an annual average rate of 8.4 percent over the five -50 -50 years ending in the second quarter of 2020. Provisions Realized Gains/Losses Membership in federally insured credit unions Noninterest Expense on Investments -100 -100 has grown 21 percent over the past five years, 2006 2008 2010 2012 2014 2016 2018 2020 reaching over 122 million members as of the Note: Federally-insured credit unions. Source: NCUA Values are annualized. second quarter of 2020.
The COVID-19 pandemic has presented the credit union system and its members with numerous challenges. The data generally show, however, that financial performance at credit unions was relatively solid in the first half of the year, despite the sharp rise in unemployment and a record-setting drop in economic activity. Net income at consumer credit unions amounted to $9.4 billion on an annualized basis in the second quarter of 2020, a sharp decline of 35 percent from the same period in 2019 (Chart 3.5.1.33). That fall was largely due to a continued jump in provisioning for loan and lease losses and credit loss expenses as a result of the deterioration in economic conditions.
The amount of outstanding loans at credit unions increased by 6.6 percent over the year ending in the second quarter of 2020, up slightly from the 6.4 percent pace registered during the same period a year earlier. Credit union real estate loans outstanding, which represent roughly half of the industry’s loan portfolio, increased a sizeable 10 percent in the most recent four-quarter period. Record-low mortgage rates have fueled strong real estate lending. The industry also posted a large increase in commercial loans, due mainly to Paycheck Protection Program lending. In contrast, auto loans, which represent one-third of the credit union loan portfolio, grew only 1.1 percent over the year ending in the second quarter of 2020, as loans for new autos contracted.
Financial Developments 93 Overall loan performance remained strong in the first half of 2020 despite the economic stresses and a rising level of unemployment. The system-wide delinquency rate declined to 58 basis points in the latest quarter, nearly matching a 13-year low reached last year. The delinquency rates on fixed-rate real estate loans and auto loans stood at 41 basis points and 47 basis points, respectively. The delinquency rate on credit cards (just over 5 percent of total credit union loans) declined in the second quarter but remained elevated at 101 basis points.
The credit union system experienced a return on average assets (ROAA) of just 57 basis points at an annual rate in the second quarter of 2020, down sharply from 97 basis points a year earlier. Both interest income and non-interest income were up modestly, while the NIM among all credit unions declined to 288 basis points from 318 basis points a year earlier.
Based on various standard measures, smaller credit unions have continued to underperform larger credit unions. These smaller institutions account for the bulk of institutions but a very modest (and shrinking) share of assets and members. For example, credit unions with less than $100 million in assets account for 67 percent of the number of institutions, but only 5.4 percent of assets, while credit unions with more than $1 billion in assets account for 70 percent of system-wide assets and 65 percent of credit union members. ROAA at the smaller institutions averaged 36 basis points on an annualized basis in the second quarter of 2020, while ROAA at credit unions with more than $1 billion in assets was higher at 63 basis points. At the same time, the loan delinquency rate for smaller credit unions was 87 basis points in the second quarter of the year, compared with 55 basis points at the $1 billion-plus institutions.
Interest rates across the maturity spectrum have fallen to historical lows amid the COVID-19 crisis. Credit union interest-sensitive deposits as a share of total deposits have fallen from over 60 percent a decade earlier to less than 50
94 2020 FSOC // Annual Report percent. The share of money market accounts 3.5.1.34 Credit Union Deposits and IRA deposits has also been trending 3.5.1.34 Credit Union Deposits lower (Chart 3.5.1.34). A measure of long- Percent As Of: 2020 Q2 Percent term assets—which consists of fixed-rate first 36 68 Interest-Sensitive Deposit mortgages and investments with a term longer Share (left axis) 34 than three years—has been relatively steady at 64 Money Market and IRA Deposit Share (right axis) 32 just under 28 percent of total assets in recent 60 30 years. That share remains elevated compared to 56 levels that prevailed 10 to 15 years ago (Chart 52 28 3.5.1.35). 48 26
The overall investment share of the asset side 44 24 of credit union balance sheets has shrunk 2006 2008 2010 2012 2014 2016 2018 2020 Note: Federally-insured credit unions. Interest-sensitive in recent years, while the loan share has deposit share includes money market and IRA deposit Source: NCUA share, share certificates, and certain other deposits. increased. Over the past five years, the share of investments has declined from roughly 24 percent of total assets to 18 percent currently. Over the same period, the share of assets 3.5.1.35 Credit Union Net Long-Term Assets accounted for by loans rose from roughly 64 3.5.1.35 Credit Union Net Long-Term Assets percent to 65 percent (Chart 3.5.1.36). Percent of Total Assets As Of: 2020 Q2 Percent of Total Assets 40 40 Investments Longer Than 3 Years The loan-to-deposit ratio at credit unions Fixed Rate First Mortgages declined in the second quarter to 76.2 percent 30 30 but remains higher than levels from a decade ago. An elevated loan share has generally 20 20 helped to support credit union profitability in recent years. Consumers pulled back on spending in the first half of the year, driving the 10 10 personal savings rate up to an all-time high. As a result, total deposits at credit unions surged 0 0 2006 2008 2010 2012 2014 2016 2018 2020 by 16.5 percent in the year ending in the second quarter, the largest four-quarter increase in Source: NCUA several decades.
The credit union industry remained well- capitalized in the first half of the year. The 3.5.1.36 Credit Union Composition of Assets 3.5.1.36 Credit Union Composition of Assets overall net worth ratio in the second quarter Percent of Total Assets As Of: 2020 Q2 Percent of Total Assets of 2020 was 10.5 percent. In ordinary times, 100 100 Loans Investments under statutory guidelines, a credit union is considered “well capitalized” if it holds a net 80 80 worth ratio at or above 7 percent. 60 60 While still maintaining the safety and 40 40 soundness of the credit union system, the NCUA Board has undertaken a number of 20 20 measures to provide regulatory relief, flexibility, and support for credit unions as they respond 0 0 to the COVID-19 pandemic. Federal legislation 2006 2008 2010 2012 2014 2016 2018 2020 has also provided assistance. For instance, the Source: NCUA
Financial Developments 95 CARES Act instituted temporary changes to 3.5.2.1 Number of Broker-Dealers and Industry Net Income 3.5.2.1 Number of Broker-Dealers and Industry Net Income the Federal Credit Union Act to expand the Number of Firms As Of: 2020 Q2 Billions of US$ borrowing authority of the Central Liquidity 5500 60 Facility (CLF). This enhanced an important Number of Broker-Dealers (left axis) Net Income (right axis) 50 liquidity backstop for the industry. The NCUA 5000 has also awarded $3.7 million in grants and no- 40 4500 interest loans to 162 low-income credit unions, 30 helping them provide affordable financial 4000 services to their members and communities 20 during the COVID-19 pandemic. 3500 10 3.5.2 Nonbank Financial Companies 3000 0 2009 2011 2013 2015 2017 2019 3.5.2.1 Securities Broker-Dealers Note: 2009 – 2019 data as of Q4 and 2020 As of June 2020, there were approximately Source: FINRA net income is YTD through Q2. 3,600 securities broker-dealers registered with the SEC, a decline of 3.0 percent from year- end 2019, reflecting a steady decline since 2009 (Chart 3.5.2.1). Aggregate revenues in 3.5.2.2 Broker-Dealer Revenues 3.5.2.2 Broker-Dealer Revenues the sector have trended higher in recent years, Billions of US$ As Of: 2020 Q2 Billions of US$ increasing 7 percent in 2019 relative to 2018 500 500 (Chart 3.5.2.2).
400 400 Broker-dealers were impacted by COVID-19 pandemic-related market volatility and work- 300 300 from-home restrictions in 2020. In response, the SEC and FINRA have provided targeted 200 200 regulatory assistance and relief in connection with pandemic-related challenges. 100 100
0 0 COVID-19 pandemic-related market volatility 2009 2011 2013 2015 2017 2019 in 2020 resulted in significant increases in Source: FINRA trading volumes across products. The industry experienced some operational issues due to increased volumes, such as website outages. Aggregate receivables from fails-to-deliver at all broker-dealers more than doubled between February and March month-ends but returned to average levels by April month-end.
Aggregate YTD June 2020 net income equaled full-year 2019 net income reflecting increased market activity and lower interest and other expenses. For the largest broker-dealers, gains from interest rate/fixed income products driven by wide bid-ask spreads and increased volatility were offset by losses in equities. Trading commission revenue increased on the rise in market volumes, particularly in equities.
96 2020 FSOC // Annual Report Underwriting revenue rose largely as a result of 3.5.2.3 Broker-Dealer Assets and Leverage an increase in debt issuances. 3.5.2.3 Broker-Dealer Assets and Leverage Trillions of US$ As Of: 2020 Q2 Ratio 8 25 The U.S. broker-dealer sector remains relatively Total Assets (left axis) Leverage (right axis) concentrated. The ten largest broker-dealers 20 account for 57 percent of industry assets, 30 6 percent of industry total revenues, and 40 15 percent of industry net income. 4 10
Total assets in the U.S. broker-dealer industry 2 increased to $4.7 trillion as of the second 5 quarter of 2020 but were well below the peak 0 0 of $6.8 trillion in 2007 (Chart 3.5.2.3). Assets 2005 2007 2009 2011 2013 2015 2017 2019 of the largest broker-dealers, which act as Note: Leverage is the ratio of total assets to total regulatory Source: FINRA capital. 2005 – 2019 data as of Q4 and 2020 data as of Q2. market makers, increased 12 percent between the fourth quarter of 2019 and the first quarter of 2020, driven by a 20 percent increase in securities and spot commodities owned. Broker- dealers typically obtain leverage through the use of secured lending arrangements such as repos and securities lending transactions. Broker-dealer leverage, measured in various ways, has declined markedly since 2007. For example, leverage measured as total assets over regulatory capital (defined as ownership equity qualified for net capital and allowable subordinated liabilities) declined to 10.5 in aggregate as of June 2020, down from 11.1 as of year-end 2019, but still remains well below the pre-crisis peak of 21 in 2006.
3.5.2.2 REITs Real estate investment trusts (REITs) are companies that own or finance income- producing real estate across a range of property sectors. Broadly speaking, REITs can be broken down into two major categories: equity REITs, which typically own and operate income-producing real estate, and mortgage REITs (mREITs), which provide financing for purchasing or originating mortgages and MBS. mREITs can be further divided into agency mREITs, which invest in agency MBS, and non- agency mREITs, which invest in a broad range of mortgage-related assets. mREITs tend to deploy significantly more leverage than equity REITs, and the amount of leverage used by mREITs is largely dependent
Financial Developments 97 on the credit quality and liquidity of the 3.5.2.4 REITs Total Assets 3.5.2.4 REITs Total Assets underlying investments. mREITs typically Billions of US$ As Of: 2020 Q2 Billions of US$ fund their operations through the short-term 1000 1000 repo markets, and the combination of high Equity REITs leverage and short-term borrowing can lead mREITs 800 800 to considerable funding risk. In addition to funding risk, non-agency mREITs can be 600 600 exposed to credit and liquidity risks. In normal
400 400 market conditions, these risks typically do not extend to agency mREITs. 200 200 The size of the REIT industry grew considerably 0 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 prior to the COVID-19 pandemic, which Source: Federal Reserve, Note: Statistical Release Z.1, “Financial Accounts can be primarily attributed to the growth of Haver Analytics of the United States.” mREITs. As of the fourth quarter of 2019, mREIT assets totaled $681 billion, a $513 billion increase from the fourth quarter of 2009 (Chart 3.5.2.4). Much of this growth has been 3.5.2.5 mREIT Stock Performance concentrated in the largest mREITs, and as of 3.5.2.5 mREIT Stock Performance Index As Of: 30-Sep-2020 Index the fourth quarter of 2019, three mREITs held 150 150 a combined $262 billion in agency MBS and S&P 500 TBA securities, or approximately 75 percent of 125 Financials 125 mREITs total mREIT agency MBS and TBA securities
100 100 holdings. The growth of mREITs has been accompanied by an increase in repo financing, 75 75 which increased from $90 billion as of the fourth quarter of 2009 to $379 billion as of the 50 50 fourth quarter of 2019.
25 25 Sep:2019 Dec:2019 Mar:2020 Jun:2020 Sep:2020 mREIT assets fell considerably in the first half Note: Indexed to 100 as of 9/30/2019; mREITs represents the BREIT Mortgage Index; Financials of 2020, as the sector came under significant Source: Bloomberg, L.P. represents the S&P 500 Financials Subindex. pressure during the COVID-19 market stress. As of the second quarter of 2020, mREIT assets totaled $502 billion, a 26 percent decline relative to the fourth quarter of 2019. The stress in the sector was most acute in March, with mREIT stock prices falling by nearly 70 percent between March 4 and April 3 (Chart 3.5.2.5). During this period, prices of mortgage-linked assets fell considerably, which triggered margin calls from mREIT lenders. To raise liquidity, mREITs sold mortgage collateral which, similar to Treasury sales, expanded dealer balance sheets and impacted term MBS repo intermediation and pricing. However, given the decline in liquidity provisioning in the MBS market, these sales led to a sharp widening of the MBS-Treasury spread, further straining mREIT
98 2020 FSOC // Annual Report balance sheets and creating a negative feedback 3.5.2.6 Agency MBS Spread to Treasuries loop for market functioning (Chart 3.5.2.6). 3.5.2.6 Agency MBS Spread to Treasuries Basis Points As Of: 30-Sep-2020 Basis Points Quarterly changes in mREIT balance sheets 200 200 can provide insight into the magnitude of this 175 175 deleveraging campaign. In the first quarter of 150 150 2020, mREIT exposures to agency securities fell by $124 billion or 37 percent compared to 125 125 the previous quarter. Similarly, mREIT repo 100 100 borrowing fell by $119 billion or 31 percent over the quarter. Ultimately, FOMC actions 75 75 announced in March, which included purchases 50 50 of agency MBS and CMBS, gradually improved 2015 2016 2017 2018 2019 2020 liquidity conditions and market functioning in Note: Fannie Mae 30-year current-coupon Source: Bloomberg, L.P. spread to the 5/10-year Treasury blend. these markets.
3.5.2.3 Money Market Mutual Funds MMFs are a type of mutual fund that are generally used by investors to manage their cash needs. The COVID-19 pandemic caused stress in certain MMFs when, as noted in Box D, market participants shifted risk preferences towards cash and other highly liquid instruments. This rapid shift resulted in outflows from prime institutional MMFs, which saw assets decline in March 2020 by $77 billion. During the third week of March alone, prime institutional MMFs saw outflows of around $88 billion, or 8 percent of their net assets. Anecdotally, some of the outflows in March from prime institutional MMFs can be attributed to investors’ concerns that prime institutional funds would impose gates and fees if their weekly liquid assets (WLAs), the share of assets convertible to cash within five business days, dropped below 30 percent of total assets. In response to market dislocations, two banks purchased assets from three affiliated prime MMFs to increase the funds’ WLAs. One MMF saw its weekly liquid assets decline to 28 percent of total assets.
Shortly after the stress in March, as noted in Section 3.4.1, the Federal Reserve announced the establishment of the MMLF, which helped to improve liquidity. Following this announcement, assets in institutional prime MMFs increased in April by roughly the same amount of their decline in March.
Financial Developments 99 3.5.2.7 MMF Assets by Fund Type Despite the stress in prime institutional MMFs in 3.5.2.7 MMF Assets by Fund Type March 2020, MMF assets in the aggregate have Trillions of US$ As Of: Sep-2020 Trillions of US$ grown significantly over the past year because, 6 6 Tax-Exempt among other things, the COVID-19 pandemic Government and Treasury 5 Prime 5 increased investors’ demand for cash and lower- risk assets. According to the SEC’s Money Market 4 4 Fund Statistics, MMF net assets totaled $4.9 3 3 trillion in September 2020, a 26 percent increase year-over-year (Chart 3.5.2.7). Inflows were 2 2 concentrated in government and Treasury MMFs, 1 1 which saw their assets increase by $1.1 trillion, or 41 percent, from September 2019. Government 0 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 and Treasury MMFs’ collective share of total assets increased to 77 percent in September 2020 from Source: SEC 69 percent in September 2019.
Over the twelve months ended September 2020, prime MMF assets decreased by $70 billion, or 6.6 percent. Prime MMFs’ share of total MMF assets declined to 20 percent in September 2020, down from 28 percent in September 2019. Net assets in tax-exempt MMFs have declined by $18 billion over the past twelve months to $121 billion as of September 2020.
The long-term trend since 2016 towards consolidation in the MMF sector, which slowed down in 2019, accelerated in 2020. As of September 2020, there were 352 MMFs, down from 369 funds in September 2019. Similarly, concentration in the MMF industry has gradually increased over the past several years. As of September 2020, the five largest MMF complexes managed 53 percent of total assets, up from approximately 46 percent at year-end 2015. Further, three MMF sponsors have recently closed some of their prime MMFs, potentially resulting in additional concentration. More specifically, two sponsors liquidated three institutional prime funds, which represented 3.6 percent of institutional prime assets as of year-end 2019. One retail prime fund, representing 28 percent of retail prime fund assets as of year-end 2019, was converted into a government fund.
Since the SEC money market fund reforms in October 2016, prime institutional and tax- exempt institutional MMFs have been required to price their shares at market, known as Floating
100 2020 FSOC // Annual Report Net Asset Value (FNAV), rather than at amortized 3.5.2.8 Liquid Asset Shares of Prime MMFs cost, known as Constant Net Asset Value. The 3.5.2.8 Liquid Asset Shares of Prime MMFs portion of assets of prime and tax-exempt Percent of Total Assets As Of: Sep-2020 Percent of Total Assets institutional MMFs, which are required to transact 70 70 at FNAV, has declined to 15 percent in September 60 Weekly Liquid - Institutional 60 2020 from 17 percent in September 2019. 50 Weekly Liquid - Retail 50
Yields on MMFs declined after the Federal 40 40 Reserve cut its benchmark rate twice in March 30 Daily Liquid - Institutional 30 2020. The average gross 7-day yield on prime institutional MMFs dropped to 0.2 percent in 20 Daily Liquid - Retail 20 September 2020 from 2.1 percent in September 10 10 2019. The average gross 7-day yield on Treasury 2017 2018 2019 2020 MMFs was 0.2 percent in September 2020, down Source: SEC Note: Weighted by fund size. from 2.0 percent in September 2019. Average gross 7-day yields for tax-exempt institutional MMFs were 0.2 percent in September 2020 down from 1.6 percent in September 2019. These low 3.5.2.9 Weighted Average Maturities by Fund Type yields have resulted in many MMF sponsors 3.5.2.9 Weighted Average Maturities by Fund Type waiving their fees to keep the yields earned by Days As Of: Sep-2020 Days investors above zero. 60 60 Government and Treasury Prime Prime institutional MMFs’ daily liquidity—the 50 Tax-Exempt 50 share of assets convertible to cash within one business day—averaged 53 percent of assets 40 40 in September 2020, up from 38 percent in 30 30 September 2019. This substantially exceeds the
10 percent required by SEC rules. WLAs for 20 20 prime institutional MMFs averaged 66 percent in September 2020, also up from 54 percent in 10 10 September 2019 and well above the 30 percent 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 minimum required under SEC rules (Chart Source: SEC Note: Weighted by fund size. 3.5.2.8).
The WAM of fund assets provides an indication of the sensitivity of fund returns to changes in market interest rates. MMF managers tend to maintain a lower WAM during periods of rising rates and extend their WAMs in anticipation of stable or declining rates. Prime institutional MMF WAM averaged 40 days in September 2020 versus 31 days in September 2019. These averages were well below the 60-day maximum permitted under SEC rules (Chart 3.5.2.9).
The weighted average life (WAL) of fund assets provides an indication of the credit risk of an MMF’s portfolio. MMFs that have higher WALs are subject to increased risk when credit spreads
Financial Developments 101 rise. Prime institutional MMF WAL averaged 59 days in September 2020 versus 62 days in September 2019. These averages were well below the 120-day maximum permitted under SEC rules.
The Federal Reserve’s overnight reverse repurchase agreement facility (ON RRPF) is a supplementary policy tool that it uses to set the floor on rates, to keep the federal funds rate in the target range set by the FOMC. Eligible MMFs have invested in the ON RRPF since regular testing began in September 2013. Given the low rate paid on investments in the ON RRPF, MMFs generally use it when better investment opportunities are not available in the afternoon market. As of the end of September 2020, when the ON RRPF paid a zero percent rate, MMFs’ investments in the ON RRPF were low at $850 million. In contrast, MMFs invested around $285 billion in the ON RRPF at the end of March 2020, despite a zero percent rate.
Use of the ON RRPF at the end of March peaked due to a confluence of factors. Among other things, massive inflows into government funds drove repo rates to zero as repo supply outpaced demand, which was further exacerbated by the effects of window-dressing by certain dealers typically seen around quarter-end. Supply of Treasury bills was also light as the passage of the CARES Act occurred only a few days before quarter-end prior to Treasury issuance fully ramping up. These factors led to Treasury bills in the secondary market trading in negative yield territory days before quarter-end, which left government funds with few other investment options than ON RRPF.
Repo holdings in MMFs totaled $1.1 trillion in September 2020 (down from $1.3 trillion in September 2019), or 22 percent of all assets. In 2019, Fixed Income Clearing Corporation (FICC) further expanded its sponsored repo service to include prime brokerage, broker- dealers and non-U.S. based banks in addition to custody banks, which were permitted to sponsor qualified institutional buyers onto the cleared repo platform. Over time, MMF investments in sponsored repos, which are centrally cleared
102 2020 FSOC // Annual Report by FICC, have increased significantly—from 3.5.2.10 Net Assets of the Investment Company Industry less than $1 billion in early 2017 to the all- 3.5.2.10 Net Assets of the Investment Company Industry time high of roughly $275 billion at the end of Trillions of US$ As Of: 2020 Q3 Trillions of US$ 30 30 December 2019. MMFs had just approximately Other ETFs $140 billion invested in sponsored repos at the 25 25 MMFs end of September 2020. MMFs also are holding Bond/Hybrid Mutual Funds more Treasury securities than the historical 20 Equity Mutual Funds 20 norm, with government funds and prime funds 15 15 holding 56 percent and 28 percent of their 10 10 assets in Treasury securities respectively. 5 5
3.5.2.4 Registered Investment Companies 0 0 Mutual Funds 1995 1998 2001 2004 2007 2010 2013 2016 2019 Source: ICI, Haver Note: Other is composed of unit investment trusts (UIT) and closed-end Mutual funds are investment vehicles that pool funds. Q3 2020 figures include 2019 UIT data, which are reported annually Analytics and Q2 2020 closed-end fund data, which are reported on a lag. money from many investors, invest in a variety of securities or assets, and give investors daily redemption rights. As of September 2020, net assets of equity, bond, and hybrid mutual funds 3.5.2.11 Monthly Bond Mutual Fund Flows totaled $18 trillion, or approximately 65 percent 3.5.2.11 Monthly Bond Mutual Fund Flows of total U.S. investment company assets. Excluding Billions of US$ As Of: Sep-2020 Billions of US$ MMFs, U.S. mutual funds’ net assets increased by 200 200 Tax-Exempt 0.5 percent in the first nine months of 2020 after Taxable 100 100 increasing 20 percent in 2019 (Chart 3.5.2.10).
0 0 Prior to the pandemic, fixed income mutual funds saw consistent inflows while equity mutual -100 -100 funds saw consistent outflows. Between January 2018 and February 2020, bond funds experienced -200 -200 net inflows for 23 of the 26 months and equity -300 -300 funds recorded net outflows for 24 of these 2017 2018 2019 2020 same 26 months. Over this period, bond funds experienced $384 billion in net inflows while Source: ICI, Haver Analytics Note: Net fund flows. equity funds had $674 billion in net outflows.
Flow patterns changed significantly in March 2020 amid the economic and market 3.5.2.12 Monthly Equity Mutual Fund Flows 3.5.2.12 Monthly Equity Mutual Fund Flows disruptions associated with the COVID-19 Billions of US$ As Of: Sep-2020 Billions of US$ pandemic. Mutual funds experienced a record 50 50 monthly outflow in March in terms of both 25 25 dollar amount ($348 billion) and percentage of assets (2.1 percent). Bond mutual fund outflows 0 0 were $255 billion, the highest on record, and -25 -25 represented 73 percent of total outflows. Bond mutual fund outflows moderated in April -50 -50 and flows turned positive in May, likely due to -75 -75 improved market-wide risk appetite for those assets following the announcement of various -100 -100 2017 2018 2019 2020 Federal Reserve programs (Charts 3.5.2.11, 3.5.2.12). Source: ICI, Haver Analytics Note: Net fund flows.
Financial Developments 103 3.5.2.13 Monthly Bank Loan Mutual Fund Flows During the March 2020 market turmoil, bank 3.5.2.13 Monthly Bank Loan Mutual Fund Flows loan mutual fund monthly outflows exceeded Billions of US$ As Of: Sep-2020 Billions of US$ $11 billion, second only to the December 2018 10 10 record of over $13 billion (Chart 3.5.2.13).
5 5 These funds offer investors daily redemptions and hold assets with lengthy settlement periods, 0 0 some of which may, during times of significant market stress, take longer to sell and settle -5 -5 than the redemption period offered. Bank loan funds have experienced outflows for -10 -10 23 consecutive months through September 2020, as floating rate notes became less -15 -15 2017 2018 2019 2020 attractive relative to high-yield bonds, given the anticipation for continued stable or falling Source: Morningstar, Inc. Note: Net fund flows. interest rates. Between November 2018 and September 2020, cumulative outflows from bank loan mutual funds totaled $75 billion, or more than 54 percent of AUM. Bank loan 3.5.2.14 Monthly High-Yield Mutual Fund Flows 3.5.2.14 Monthly High-Yield Mutual Fund Flows funds met redemptions throughout this period Billions of US$ As Of: Sep-2020 Billions of US$ of outflows, including during the significant 15 15 market stress in March 2020. Over the same
10 10 period, high-yield bond mutual fund inflows totaled $24 billion, or 9.8 percent of AUM, as 5 5 modest net outflows for most of the period were 0 0 more than offset by April-August inflows of $39 billion (Chart 3.5.2.14). -5 -5
-10 -10 Investors continued to gravitate away from actively managed equity mutual funds and -15 -15 2017 2018 2019 2020 towards lower-cost, index-based equity funds. According to Morningstar, index-based mutual Source: Morningstar, Inc. Note: Net fund flows. funds and ETFs represented 51 percent of U.S. equity fund assets as of September 2020, up from 26 percent at year-end 2009. Between January 2019 and September 2020, inflows 3.5.2.15 Cumulative Equity Fund Flows to index-based U.S. and international equity 3.5.2.15 Cumulative Equity Fund Flows funds totaled $205 billion, while their actively Billions of US$ As Of: Sep-2020 Billions of US$ 400 400 managed counterparts saw outflows of $531 billion (Chart 3.5.2.15). In taxable bond 200 200
0 0
-200 -200 U.S. Passively Managed -400 International Passively Managed -400 International Actively Managed U.S. Actively Managed -600 -600 Jan:2019 Jul:2019 Jan:2020 Jul:2020
Note: Includes ETFs and mutual Source: Morningstar, Inc. funds. Cumulative net fund flows.
104 2020 FSOC // Annual Report mutual funds, both actively managed and index- 3.5.2.16 Cumulative Equity and Fixed Income Fund Flows based funds have continued to experience 3.5.2.16 Cumulative Equity and Fixed Income Fund Flows inflows (Chart 3.5.2.16). Nevertheless, index- Billions of US$ As Of: Sep-2020 Billions of US$ based funds are gaining market share and as of 600 600 September 30, 2020, index-based mutual funds 400 400 and ETFs represented 35 percent of taxable 200 200 bond fund assets, up from 15 percent at year- end 2009. 0 0
-200 -200 Exchange-Traded Funds Fixed Income Passively Managed Exchange-traded products (ETPs) include ETFs -400 Fixed Income Actively Managed -400 Equity Passively Managed registered under the Investment Company Act Equity Actively Managed -600 -600 of 1940 (’40 Act), non-’40 Act registered ETPs Jan:2019 Jul:2019 Jan:2020 Jul:2020 (such as those that primarily hold commodities Note: Includes ETFs and mutual Source: Morningstar, Inc. funds. Cumulative net fund flows. or physical metals), and exchange-traded notes. ETFs registered under the ’40 Act, which account for over 99 percent of listed ETP assets, continue to grow at a faster pace than mutual 3.5.2.17 U.S.-Listed ETF AUM funds and other SEC-registered investment 3.5.2.17 U.S.-Listed ETF AUM vehicles. By the third quarter of 2020, these Trillions of US$ As Of: Sep-2020 Trillions of US$ funds accounted for 17 percent of U.S. 5 5 AUM Cumulative Market Appreciation investment company assets, up from 12 percent 4 4 Cumulative Flows to ETFs in 2015 and 7.6 percent in 2010. 3 3
After rising 30 percent in 2019, ETF assets rose 2 2 another 7 percent over the first nine months of 2020, settling at $4.7 trillion in September. 1 1
Recent years’ asset growth has been driven 0 0 primarily by inflows, which totaled $2.8 trillion -1 -1 since 2009, rather than market appreciation 2009 2011 2013 2015 2017 2019 (Charts 3.5.2.17, 3.5.2.18). Source: Morningstar, Inc.
3.5.2.18 ETF Assets by Category of Investment 3.5.2.18 ETF Assets by Category of Investment Trillions of US$ As Of: Sep-2020 Trillions of US$ 5 5
Commodities 4 Alternative 4 Allocation Fixed Income 3 Equity 3
2 2
1 1
0 0 2009 2011 2013 2015 2017 2019
Source: Morningstar, Inc.
Financial Developments 105 3.5.2.19 Monthly ETF Flows: Fixed Income Funds Equity and fixed income ETFs experienced 3.5.2.19 Monthly ETF Flows: Fixed Income Funds inflows for most months in 2019 and early 2020, Billions of US$ As Of: Sep-2020 Billions of US$ with equity funds showing more variability. 40 40 Tax-Exempt As the COVID-19 pandemic disrupted the Taxable economy and financial markets in March 2020, 20 20 fixed income ETFs experienced record monthly outflows, totaling $21 billion or 2.3 percent of 0 0 assets. Following the dislocation caused by the COVID-19 pandemic, the market stabilized
-20 -20 and bond ETF flows and fixed income ETFs experienced inflows totaling $143 billion between April and September 2020 (Chart -40 -40 2017 2018 2019 2020 3.5.2.19). Despite the March 2020 market turmoil, equity ETF flows remained positive, Source: Morningstar Direct Note: Net fund flows. totaling $16 billion for the month (Chart 3.5.2.20).
A number of fixed income ETFs began 3.5.2.20 Monthly ETF Flows: Equity Funds 3.5.2.20 Monthly ETF Flows: Equity Funds trading at discounts to their NAV amid the Billions of US$ As Of: Sep-2020 Billions of US$ onset of COVID-19 pandemic-related market 80 80 dislocations, but pricing began to normalize in many bond ETFs following the Federal Reserve’s 40 40 announcement of the Secondary Market Corporate Credit Facility (SMCCF) on March
0 0 23. Following this announcement, the discount on bond ETF prices relative to NAV improved in a matter of days, and many bond ETFs traded -40 -40 close to NAV at the end of March. As part of the SMCCF, which was established to support -80 -80 2015 2016 2017 2018 2019 2020 credit to employers by providing liquidity to the market for outstanding corporate bonds, the Source: Morningstar Direct Note: Net fund flows. Federal Reserve began to purchase bond ETFs on May 12. Purchases under the SMCCF in May totaled $3.7 billion, and as of September 30, 2020, the market value of ETF holdings under 3.5.2.21 Monthly Inverse and Leveraged ETF Flows the SMCCF totaled $8.6 billion. 3.5.2.21 Monthly Inverse and Leveraged ETF Flows Billions of US$ As Of: Sep-2020 Billions of US$ 10 10 Inflows to leveraged and inverse ETFs spiked Inverse in March and April amid heightened market Leveraged 5 5 volatility associated with the onset of the COVID-19 pandemic (Chart 3.5.2.21).
0 0 The ETF industry remains concentrated, as the three largest managers account for over 80 -5 -5 percent of ETF assets, and the top ten managers account for over 95 percent of ETF assets. Over -10 -10 the first nine months of 2020, the number of 2015 2016 2017 2018 2019 2020 available ETFs increased 1.0 percent in addition Source: Morningstar Direct Note: Net fund flows. to the 5.3 percent increase in 2019.
106 2020 FSOC // Annual Report 3.5.2.5 Alternative Funds 3.5.2.22 Hedge Fund Gross and Net Assets Hedge Funds 3.5.2.22 Hedge Fund Gross and Net Assets The aggregate NAV of qualifying hedge funds, Trillions of US$ As Of: 2020 Q1 Leverage 10 2.4 which are large hedge funds with enhanced Gross Assets (left axis) reporting requirements on the SEC’s Form PF, Leverage: GAV/NAV 8 Net Assets (left axis) (right axis) in the United States was $2.9 trillion in the 2.2 first quarter of 2020, a 6.7 percent decrease 6 from the prior year. The gross asset value 2.0 (GAV) of qualifying hedge funds—which 4 reflects the effect of leverage obtained through 1.8 cash and securities borrowing—totaled $6.3 2 trillion, a 3.0 percent decrease year-over-year 0 1.6 (Chart 3.5.2.22). These figures cover the 2013 2014 2015 2016 2017 2018 2019 2020 approximately 1,800 hedge funds and 550 Note: QHF gross and net assets as Source: SEC Form PF, OFR reported on Form PF Questions 8 and 9. hedge fund advisers that have enhanced Form PF reporting requirements with the SEC.
Various measures of leverage for hedge funds overall, including measures of off-balance sheet exposures, show increasing or flat patterns over the course of the past year. GAV divided by NAV showed aggregate qualifying hedge fund leverage of 2.2 as of the first quarter of 2020, up from 2.1 in the first quarter of 2019. The aggregate qualifying hedge fund leverage ratio as measured by gross notional exposure (GNE), which includes the notional amount of derivatives but excludes repurchase agreement exposures, divided by NAV was 6.3 in the first quarter of 2020, unchanged from the previous year. When interest rate derivatives are excluded, the aggregate qualifying hedge fund GNE/NAV leverage ratio was 4.4, up from 4.2 in the first quarter of 2019.
Financial Developments 107 The aggregate level of hedge fund borrowing 3.5.2.23 Hedge Fund Secured Financing has increased significantly in recent years. As of 3.5.2.23 Hedge Fund Secured Financing Trillions of US$ As Of: Mar-2020 Trillions of US$ year-end 2019, hedge fund borrowing totaled 4 4 $3.2 trillion, up from $2.1 trillion at year-end Other Secured Financing 2016 (Chart 3.5.2.23). The recent growth in Prime Broker 3 Repo 3 borrowing has been driven primarily by repo borrowing, which grew from $0.7 trillion in December 2016 to $1.3 trillion in December 2 2 2019. Over this same time period, prime broker borrowing grew from $1.1 trillion to $1.4 1 1 trillion. In March 2020, aggregate hedge fund borrowing contracted by the most in over seven 0 0 years, with month-over-month repo and prime 2013 2014 2015 2016 2017 2018 2019 2020 Note: QHF secured borrowing as broker borrowing declining by $90 billion and Source: SEC Form PF, OFR reported on Form PF Question 43. $275 billion, respectively.
Hedge funds obtain the majority of financing from G-SIBs, with U.S. G-SIBs accounting 3.5.2.24 Hedge Fund Borrowing: Composition of Creditors 3.5.2.24 Hedge Fund Borrowing: Composition of Creditors for approximately 50 percent of funding and Trillions of US$ As Of: 2020 Q1 Trillions of US$ foreign G-SIBs accounting for an additional 35 4 4 percent of funding (Chart 3.5.2.24). While the Other Foreign G-SIB percent of financing that is subject to significant 3 U.S. G-SIB 3 rollover risk has declined in recent years, over 50 percent of financing is reported on Form PF
2 2 as being secured for only seven days or fewer (Chart 3.5.2.25). Since filers may default to selecting the “1-days or less” bucket on Form PF 1 1 in certain situations, such as when a creditor is allowed to demand more collateral, the data 0 0 may be overstating the amount of financing that 2013 2014 2015 2016 2017 2018 2019 2020 Note: QHF creditors as reported Form is truly secured for seven days or fewer. Source: SEC Form PF, OFR PF Question 47.
3.5.2.25 Hedge Fund Financing Liquidity 3.5.2.25 Hedge Fund Financing Liquidity Percent As Of: 2020 Q1 Percent 100 100
80 80
60 60
40 40
20 20
0 0 2013 2014 2015 2016 2017 2018 2019 2020 0-7 Days 8-30 Days 30+ Days
Note: QHF financing liquidity as Source: SEC Form PF, OFR reported on Form PF Question 46.
108 2020 FSOC // Annual Report Hedge funds deploy a wide range of strategies 3.5.2.26 Hedge Fund Gross Exposures by Asset Class and are invested in a various products and asset 3.5.2.26 Hedge Fund Gross Exposures by Asset Class classes (Chart 3.5.2.26). As of the first quarter As Of: 2020 Q1 of 2020, qualifying hedge funds’ GNE totaled $2.1T Interest Rate Derivatives $18 trillion, of which $12 trillion, or 65 percent, $1.1T Foreign Exchange Equities were attributed to rates products (interest rate $5.5T $3.2T Other derivatives, U.S. government debt, and other U.S. Government sovereign debt) or FX products. Equity and Sovereign Ex U.S. Credit credit products accounted for less than 25 $3.3T percent of GNE.
$1.9T According to eVestment data, which covers a $1.1T Note: QHF gross notional exposures as reported smaller percentage of the hedge fund industry on Form PF Questions 26 and 30. Excludes repurchase agreements. Options reported as when compared to Form PF, the hedge fund delta adjusted notional value. Interest rate Source: SEC Form PF, OFR derivatives reported as 10-year bond-equivalents. industry experienced net outflows of $102 billion, or roughly 3 percent of AUM, in 2019 and net outflows of $48 billion, or 1.5 percent of AUM, over the first nine months of 2020. Outflows were concentrated in hedge funds that focus on macro, directional credit, managed futures, and long-short equity strategies. These categories of funds saw roughly $86 billion in outflows during 2019 and $50 billion in outflows during the first nine months of 2020. Event-driven funds and convertible arbitrage funds were the only strategy types to see inflows during the first nine months of 2020. 2020 hedge fund returns, as provided by the Hedge Fund Research’s HFRI Fund Weighted Composite Index, stood at 0.5 percent through September 30, 2020.
Financial Developments 109 3.5.2.27 Hedge Fund Treasury Exposures Hedge Fund U.S. Treasury Exposures 3.5.2.27 Hedge Fund Treasury Exposures Over the past several years, hedge funds have Billions of US$ As Of: Mar-2020 Billions of US$ increased their exposures to U.S. Treasuries. A 1500 1500 significant proportion of this growth has been 1000 1000 concentrated in relative value hedge funds that
500 500 seek to exploit pricing discrepancies between similar products or securities. A popular relative 0 0 value strategy has been the “cash-futures basis
-500 -500 trade,” whereby funds try to capture the spread Net between the implied repo rate and general -1000 -1000 Long repo rates over the term of the trade. Entering Short -1500 -1500 into this trade involves selling a Treasury 2013 2014 2015 2016 2017 2018 2019 2020 futures contract, buying a Treasury security Note: QHF Treasury exposures as reported deliverable into that contract with repo funding Source: SEC Form PF, OFR on Form PF Questions 26 and 30. from dealer intermediaries, and delivering the security at contract expiry.
Funds often leverage the basis trade several times through overnight or term repo borrowing, leaving those reliant on overnight financing vulnerable to disruptions in repo markets. Without the ability to rollover short- term financing at similar rates, funds can rapidly incur heavy losses, as reportedly occurred during September 2019, when overnight repo rates spiked from less than 2.5 percent to over 6 percent. Similarly, funds are vulnerable to volatility in cash or futures markets and may face unsustainable margin calls in the event of large mark-to-market losses.
Hedge funds’ GNE to Treasuries totaled $2.3 trillion in February 2020, up from $1.3 trillion two years earlier (Chart 3.5.2.27). During this period, long and short Treasury exposures increased in tandem, resulting in little change in funds’ net exposure to Treasuries. As evident through the CFTC’s Commitment of Traders Report, the increase in funds’ short Treasury exposure has primarily been through futures contracts, consistent with the growth of the basis trade (see Section 3.4.3.1). The growth in funds’ exposures to Treasuries has coincided with a significant increase in hedge fund repo borrowing. Total repo borrowing peaked at $1.5 trillion in February 2020, a $660 billion increase from two years prior.
110 2020 FSOC // Annual Report During the month of March, hedge funds’ 3.5.2.28 M&A Loan Volume for Private Equity-Backed Issuers gross Treasury exposures declined by over 3.5.2.28 M&A Loan Volume for Private Equity-Backed Issuers $400 billion, which can be partly attributed to Billions of US$ As Of: 30-Sep-2020 Billions of US$ 250 250 leveraged funds unwinding the basis trade. This Non-LBO LBO unwinding may have exacerbated illiquidity in 200 200 the Treasury markets (see Box B). 150 150 Private Equity According to the SEC’s year-end 2019 Private 100 100 Funds Statistics Report, the GAV of private equity funds in the United States totaled $3.7 50 50 trillion in the fourth quarter of 2019, a 17 0 0 percent increase from the fourth quarter of 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 YTD 2018. The funds’ NAV totaled $3.3 trillion, a 17 Source: S&P LCD percent increase over that same period. These figures cover over 14,000 private equity funds, for which approximately 1,350 private equity advisers filed information on Form PF.
The private equity industry remains concentrated. Large private equity advisers filing Form PF—which are defined as those with $2 billion or more in AUM—made up 24 percent of all private equity advisers filing Form PF in the fourth quarter of 2019 and managed 74 percent of gross assets. Pension funds are the largest beneficial owners of funds managed by large private equity advisers, accounting for 29 percent of net assets; other private funds account for 19 percent, foreign official sector investors account for 11 percent, and insurance companies account for 6.2 percent.
Acquisition-related activity backed by private equity trended upwards from 2015 to 2018, hitting a record $230 billion in 2018, before slowing in 2019 to $150 billion (Chart 3.5.2.28). Private equity merger and acquisition (M&A) activity fell dramatically as the coronavirus pandemic manifested, totaling $72 billion through the end of September 2020. Leveraged buyout (LBO) activity accounted for 71 percent of total private equity M&A activity in the first nine months of 2020, compared to 61 percent for the preceding five years.
While private equity firms have raised 40 percent less in the first half of 2020 than they did for the same period in 2019, these firms are
Financial Developments 111 holding a record amount of uncommitted capital may have a different level of granularity, be in a earmarked for buyouts with over $800 billion at the different format, and cover a different time period end of 2019, which is up more than $250 billion than disclosures concerning similarly situated since 2016. This increase suggests that deal-making funds. There are, however, anecdotal reports activity could pick up once the uncertainty of the showing that, while some plans made substantial current crisis passes. Moreover, despite declines investment gains in the second quarter of 2020, in overall deal-making, COVID-19 has accelerated annual returns have fallen short of longer-term the growth of buyout firms focused on technology targets. companies, which in general have performed well through the crisis. According to Preqin Ltd., Single-Employer Private Plans through July 6, 2020, approximately $30 billion, or According to the Milliman Corporate Pension roughly one-third of private equity fundraising, has Funding Study, the funded ratio of the 100 largest gone towards technology company buyouts, up from single-employer private defined benefit plans rose just more than 10 percent during 2016. to 88 percent as of year-end 2019 compared to 87 percent as of year-end 2018. The funded percentage 3.5.2.6 Pension Funds of a plan is its assets relative to the estimated value Defined benefit pension plans are significant holders of plan liabilities. Milliman estimates that the of financial assets. As of the second quarter of 2020, funded ratio for the 100 largest corporate defined the total pension fund entitlements funded by assets benefit pension plans in the United States had an of U.S. private and public defined benefit pensions aggregate funded ratio of 84 percent at the end of were $9.9 trillion, 5.5 percent higher than one year September 2020. earlier. At the same time, defined benefit pension fund entitlements rose to $16 trillion, a 2.2 percent Multiemployer Plans increase compared to the second quarter of 2019. Milliman estimates that the aggregated funded percentage of multiemployer private defined benefit Sponsors of pension plans strive to keep pace with plans as of June 2020 was 82 percent, down from 85 the benefits owed to beneficiaries. As noted in Box percent at year-end 2019. While the Pension Benefit G, the low-for-long interest rate environment may Guaranty Corporation (PBGC) projects that the therefore result in sponsors needing to increase majority of multiemployer plans will remain solvent, contributions or act in ways that increase a plan’s risk some plans appear unable to raise contributions profile. For example, sponsors may use plan assets sufficiently to avoid insolvency. According to the to assume greater levels of investment risk, such as PBGC 2019 Projections Report, 124 plans have employing high amounts of leverage or increasing declared that they will likely face insolvency over the exposure to higher-risk or illiquid asset classes, such next 20 years. as hedge funds, private equity funds, and real estate, in an effort to meet longer-term funding targets. If The PBGC projects that its Multiemployer a pension plan needs to sell assets to raise the cash Insurance Program will have insufficient funds needed to meet benefit obligations, a plan with to cover the projected future demands from significant exposure to illiquid asset classes may multiemployer plans requiring financial assistance, be forced to sell its more liquid assets at depressed that there is a very high likelihood that the program prices, further stressing its financial position. will become insolvent by 2026, and that insolvency is a near certainty by the end of fiscal year 2027. The It is difficult to analyze the impact of the COVID-19 PBGC will be unable to provide financial assistance pandemic on defined benefit pension plans in the to pay the full level of guaranteed benefits when aggregate because the disclosure requirements the Multiemployer Insurance Program becomes differ between the single-employer private plans, insolvent. multiemployer plans, and public plans. For example, disclosures concerning a defined benefit pension plan’s return assumptions and investment strategies
112 2020 FSOC // Annual Report Public Plans 3.5.2.29 Public Plan Allocation to Alternative Assets According to Milliman, the aggregate funded 3.5.2.29 Public Plan Allocation to Alternative Assets status of the 100 largest U.S. public defined Percent As Of: 2018 Percent 35 35 benefit plans in June 2020 was 71 percent, up from 66 percent at the end of March 2020, 30 Other Alternative 30 Real Estate but down from 75 percent at the end of 2019. 25 Private Equity 25 Hedge Fund In addition, public pension fund sponsors are 20 20 permitted to assume investment returns based on their own long-run expectations by the 15 15 relevant accounting rules. Accordingly, pension 10 10 funds that do not meet their assumed return 5 5 may be overstating their current funded status. 0 0 These return assumptions may be higher than 2001 2004 2007 2010 2013 2016 recent average investment returns, and, in recent Note: Includes public plans that reported investment Source: publicplansdata.org allocations from 2001-2018. Simple average. years, several large public pension funds have revised long-term investment return expectations downward.
According to the Center for Retirement Research at Boston College, most public pension plans will close the 12-month period ended June 2020 with an annual return that is less than their expected investment returns. On average, annual returns for state and local plans were higher than their assumed returns for the same period a year earlier, with a return of 8.9 percent compared to the assumed return of 7.2 percent.
As noted in Box C, underfunded public pension funds are a significant source of fiscal pressure on several U.S. states, territories, and municipalities. Sixteen pension funds in seven states were less than 50 percent funded as of 2018. To increase expected returns and meet benefit obligations, public pension funds have steadily increased their exposure to alternative assets for years (Chart 3.5.2.29). In reaction to the COVID-19 pandemic, some state and local governments deferred or reduced scheduled pension contributions in 2020 to cover operating budget shortfalls pressuring the sustainability of the impacted plans.
3.5.2.7 Insurance Companies According to S&P Global, there were 4,537 licensed insurance companies operating in the United States during 2019, of which 2,626 were licensed as property and casualty (P&C) carriers, 1,223 were health insurers, and 688 were licensed
Financial Developments 113 as life insurance companies. Many of these are affiliated through common ownership by a holding corporation or parent insurance company.
Taken together, the largest ten P&C insurance groups have a large share of the subsector’s profit, premiums, assets, and capital. Measured as a percentage of the aggregate net income, the ten groups with the highest net incomes account for 58 percent of the subsector total. Similarly calculated, those ten groups writing the largest amount of direct premiums make up 47 percent of the market. The top ten holding the largest amount of assets account for 51 percent of all P&C assets, and the ten with the largest amounts of capital (surplus) account for 57 percent of the P&C total.
In addition, the ten largest life insurance groups comprise a large share of that subsector. Measured as a percentage of the subsector’s net income, the ten life groups with the highest net incomes make up 63 percent of the total. The ten groups with the greatest amount account for 45 percent of the subsector’s aggregate revenue from premiums, considerations, and deposits. The ten life groups with the most capital account for 43 percent of the subsector’s aggregate amount.
Measured as a percentage of the subsector’s net income, the ten largest health insurance groups with the highest net incomes make up 78 percent of the total. The ten largest groups writing the most direct premiums account for 58 percent of the subsector’s aggregate. Additionally, the ten health insurance groups with the greatest amount of capital make up 58 percent of the subsector’s total. While the market share of the largest ten firms in the subsectors is substantial in comparison to the remainder, the markets remain competitive with many active carriers.
The insurance industry is the largest, or one of the largest, investors in several key asset classes. According to the Financial Accounts of the United States, insurance companies were the
114 2020 FSOC // Annual Report largest investors in corporate and foreign bonds 3.5.2.30 Insurance Industry Net Income as of the second quarter of 2020 with $4,074 3.5.2.30 Insurance Industry Net Income billion or 28 percent of outstanding. Insurance Billions of US$ As Of: 2019 Billions of US$ companies were also major investors in mutual 100 100 Health funds ($1,522 billion), equities ($1,036 billion), Life 80 P&C 80 agency securities ($539 billion), municipal securities ($504 billion), and Treasury 60 60 securities ($420 billion). 40 40 The insurance industry experienced growth in profit, capital, total assets, and revenue from 20 20 premiums in 2019. Health insurers reported net 0 0 income growth of 19 percent, capital growth of 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 9.2 percent, total assets growth of 7.8 percent, Source: NAIC Note: Life includes accident and health. and direct written premium growth of 6.4 percent. However, 176 out of the 434 health insurers reported a decrease in income in 2019, and 100 reported a decrease in the amount of 3.5.2.31 Insurance Industry Capital and Surplus capital. The P&C carriers reported that net 3.5.2.31 Insurance Industry Capital and Surplus income grew by 3.8 percent, capital grew by Billions of US$ As Of: 2019 Percent of Total Assets 1250 80 14 percent, total assets grew by 8.9 percent, Health Capital and Surplus Health Capital and Surplus / (left axis) and direct written premiums increased by 5.1 Assets (right axis) 70 1000 Life Capital and Surplus (left P&C Capital and Surplus / axis) Assets (right axis) 60 percent. As these are 2019 end of year figures, P&C Capital and Surplus Life Capital and Surplus / (left axis) they do not reflect any effects of the COVID-19 750 Assets (right axis) 50 pandemic (Charts 3.5.2.30, 3.5.2.31). 40 500 30 Notwithstanding overall performance 20 250 measures, some insurers did not perform as 10 well as the aggregate figures would suggest; 0 0 534 out of a total of 1,127 P&C insurers 2010 2012 2014 2016 2018 Note: C&S/Assets is calculated as capital and surplus as a reported a decrease in net income for 2019, percent of net admitted assets less net admitted separate and 226 reported a decrease in the amount Source: NAIC account assets. Life includes accident and health. of capital supporting their financial activities. Similarly, the life subsector reported 18 percent growth in net income, 5.5 percent increase in capitalization, 13 percent rise in revenue from premiums, considerations, and deposits, and an 8.4 percent increase in total assets in 2019. However, 184 out of a total of 336 life insurers reported a decline in reported net income and 105 reported a decrease in capital in 2019. The sector as a whole continues to face challenges from the persistently low interest rate environment.
Financial Developments 115 Impact Thus Far from the COVID-19 Pandemic activities. On the asset side, life insurers have felt the effects of the financial markets and credit The COVID-19 pandemic has had wide-ranging trends in corporate bonds, commercial real estate, effects on the insurance industry. Insurance and less conventional investments such as CLOs, underwriting has been confronted with potentially though some of the effects of the pandemic on greater losses from trade credit guarantees, financial markets were alleviated by policy actions, event cancellations, litigation liability, workers’ such as the facilities established by the Federal compensation, higher mortality and morbidity Reserve under section 13(3) of the Federal Reserve rates, and substantial uncertainty from business Act. Life insurers also face potential reductions interruption claims and questions about potential in cash inflows and increased derivative collateral changes in demand. In addition, the financial requirements in response to higher market volatility. markets within which insurers operate experienced On the liability side, meaningful increases in price volatility, credit rating downgrades, and mortality and morbidity claims from the virus, unreliable trading liquidity. While many portions should they occur among covered individuals, would of financial markets have recovered, insurance result in greater underwriting losses. In addition, company investments will likely face uncertainty the low interest rate environment poses a long-term in regard to real estate valuations, the effects of challenge to some insurers by lowering investment mortgage forbearance, and the impact of escalating yields while increasing reserves held against future business bankruptcies. claims payments (see Box G). The COVID-19 Based on forecasts of insured losses and insurers’ pandemic could also reduce sales across a wide financial reports through the first half of 2020, range of insurance products, due to repricing. insured COVID-19 pandemic-related losses do not appear to threaten the financial stability of the The pandemic’s impact on the P&C subsector will insurance sector. However, the full and actual extent likely lead to higher-than-expected insured losses in of the impact of the pandemic and the economic some lines of insurance. This impact may be offset downturn are unknown and may exceed current to some extent by social distancing measures and a expectations. Over the longer term, the pandemic decline in economic activity, such as transportation may have a broad-based impact on industry metrics, and miles driven. The insurance lines most likely stemming from COVID-19-related insurance claims, to be adversely affected by the pandemic include macroeconomic effects, and financial market trends. those providing coverage for business interruption, workers’ compensation, professional liability, While health insurers have faced increasing claims travel, and credit insurance. Numerous legal related to COVID-19, the financial impact has been filings seeking to resolve disputes over claims for offset by individuals delaying medical care and business interruption losses has created additional procedures, though those delayed claims could uncertainty. The drop in government and corporate impact the sector in 2021. According to S&P Global, bond yields could also impact P&C insurers’ future through the second quarter of 2020, the health investment income. insurance industry reported an increase of only 1.3 percent in benefits paid and cost containment expenses compared to the prior year. The net claim and claim adjustment expense ratio declined to 80 percent from 89 percent for the second quarter. General expenses incurred increased 47 percent through June 30 impacted by the Affordable Care Act health insurance industry tax that was suspended in 2019 and resumed in 2020.
The life insurance subsector faces challenges for both its investments and hedging and underwriting
116 2020 FSOC // Annual Report 3.5.2.8 Specialty Finance 3.5.2.32 Consumer Loans and Leases Outstanding Specialty finance companies are non-depository 3.5.2.32 Consumer Loans and Leases Outstanding institutions that provide loans to consumers and Trillions of US$ As Of: Sep-2020 Trillions of US$ 2.0 2.0 businesses. The amount of financing activity by specialty finance companies decreased modestly over the past year. Specialty finance companies 1.5 1.5 Commercial Banks held approximately $727 billion of consumer loans and leases and $365 billion of business 1.0 1.0 loans and leases as of September 2020 (Charts 3.5.2.32, 3.5.2.33). 0.5 0.5 Finance Companies While specialty finance companies account 0.0 0.0 for a relatively small share of overall consumer 2001 2004 2007 2010 2013 2016 2019 lending, they have a significant footprint in cer- Note: Loans and leases owned and securitized. Series breaks Source: Federal Reserve, in December 2010 and December 2015 due to change in data tain types of consumer lending activities such as Haver Analytics collection methodology. Gray bars signify NBER recessions. auto lending. Compared to banks, which gener- ally have more stable sources of funding such as deposits, specialty finance companies are more reliant on wholesale funding and the securitiza- 3.5.2.33 Business Loans and Leases Outstanding tion market. 3.5.2.33 Business Loans and Leases Outstanding Trillions of US$ As Of: Sep-2020 Trillions of US$ Asset-Backed Securities 4.0 4.0 The COVID-19 pandemic disrupted the ABS market, halting the issuance of most ABS asset 3.0 3.0 classes and resulting in higher interest rate Commercial Banks spreads on ABS products at its onset. Issuance 2.0 2.0 declined significantly between February and
April, and the interest rate spreads on the 1.0 1.0 Finance Companies securities spiked, reflecting heightened credit risk and liquidity risk. Between February 20 and 0.0 0.0 March 19, spreads on AAA-rated tranches of 2001 2004 2007 2010 2013 2016 2019 CMBS of 5-year maturity increased by almost Note: Loans and leases owned and securitized. Series Source: Federal Reserve, break in December 2010 due to change in data collection 250 basis points to 307 basis points, and spreads Haver Analytics methodology. Gray bars signify NBER recessions. on AAA-rated tranches of 3-year maturity prime auto loan ABS widened by almost 180 basis points to 200 basis points. Although yield spreads on ABS spiked in mid-March, they did not quite reach the high levels observed during the 2008 financial crisis.
The Federal Reserve’s establishment of the Term Asset-Backed Securities Loan Facility (TALF) appears to have supported securitization market activity and helped normalize ABS spreads. Spreads on ABS categories affected by TALF stopped rising shortly after the facility was announced on March 23 and subsequently fell substantially. Issuance, which halted for all TALF-eligible asset classes in late March, gradually resumed
Financial Developments 117 in April. That said, ABS issuance through 3.5.2.34 ABS Issuance 3.5.2.34 ABS Issuance September 2020 remained significantly lower Billions of US$ As Of: Sep-2020 Billions of US$ than the pace of 2019, totaling $148 billion, 350 350 Other excluding CDOs and CLOs (Chart 3.5.2.34). 300 Student Loans 300 Finally, issuance under the support of TALF Equipment 250 Credit Card 250 has been very limited since the facility became Auto 200 200 operational in mid-June, as almost all ABS spreads of eligible asset classes were already 150 150 lower than TALF funding costs at that time. 100 100
50 50 Special Purpose Acquisition Companies 0 0 Special purpose acquisition companies (SPACs) 2006 2008 2010 2012 2014 2016 2018 2020 YTD are companies that are formed through an Note: Figures are as of year end through 2019. initial public offering (IPO) to raise funds to Source: Thomson Reuters, SIFMA 2020 figures are through September. purchase businesses or assets to be acquired after the IPO. The IPO funds are placed into an escrow or trust account where they are held until released for predetermined reasons, most commonly when the SPAC identifies a company or assets to purchase. Through the first three quarters of 2020, SPACs completed 118 IPOs, raising $44 billion, which represents more than three times the amount raised by SPACs in 2019.
3.6 Financial Market Structure, Operational Challenges, and Financial Innovation
3.6.1 3.6.1 Market Structure 3.6.1.1 Central Counterparty Clearing Cash Securities Clearing In the United States, the Depository Trust & Clearing Corporation (DTCC) is the dominant provider of clearing services for cash securities through its subsidiaries Fixed Income Clearing Corporation (FICC) and National Securities Clearing Corporation (NSCC). FICC consists of two divisions, the Government Securities Division (GSD) and the Mortgage-Backed Securities Division (MBSD). GSD provides CCP services for its customers with respect to the U.S. government securities market, and MBSD provides CCP services to the U.S. mortgage- backed securities market. NSCC serves as a CCP for virtually all broker-to-broker trades involving equities, corporate and municipal debt, ADRs, ETFs, and UITs.
118 2020 FSOC // Annual Report During the COVID-19 crisis, DTCC performed 3.6.1.1 Initial Margin Requirements: DTCC without interruption despite facing increased 3.6.1.1 Initial Margin Requirements: DTCC operational challenges and extreme market Billions of US$ As Of: 2020 Q2 Billions of US$ 60 60 volatility. Despite the significant increase NSCC FICC: MBSD in initial margin requirements at DTCC’s 50 FICC: GSD 50 clearinghouses, members generally satisfied 40 40 intraday margin calls and settlement obligations (Chart 3.6.1.1). On March 20, GSD suspended 30 30 one clearing member, Ronin Capital LLC, after 20 20 it was unable to meet capital requirements at 10 10 CME. In conjunction with their cross-margining agreement, FICC and CME jointly liquidated 0 0 2016 2017 2018 2019 2020 Ronin’s portfolio. On March 25, 2020, FICC Note: Total initial margin required as reported announced that it completed the liquidation Source: ClarusFT, PFMI in PFMI quantitative disclosures; includes Quantitative Disclosures house and client accounts. of Ronin’s portfolio without allocating losses to other GSD member firms. While FICC and NSCC performed without interruption during the heightened market volatility associated 3.6.1.2 Maximum Uncovered Exposure for DTCC with COVID-19, the clearinghouses reported 3.6.1.2 Maximum Uncovered Exposure for DTCC large margin breaches that could have led to Billions of US$ As Of: 2020 Q1 Billions of US$ significant losses in the event of a large clearing 2.0 2.0 2020 Q1 member default. 2015 - 2019 1.5 1.5 In March, the disruptions in fixed income markets led to a breakdown in the historical 1.0 1.0 relationship between TBAs and Treasuries, which materially impacted the performance 0.5 0.5 of FICC’s MBSD margin model. The extreme volatility and breakdown in correlations during 0.0 0.0 this time period was beyond the MBSD’s Value DTCC GSD DTCC MBSD DTCC NSCC at Risk (VaR) model calibration. On March 19, Source: DTCC PFMI Note: Peak uncovered exposure between Q3 2015 and Q4 2019 2020, MBSD recorded a maximum backtesting Quantitative Disclosures and Q1 2020 as reported on question 6.5.4. deficiency (i.e., margin below required minimum) of $1.5 billion, which was incurred by a portfolio with a market value greater than $100 billion whose value was sensitive to changes in interest rates. According to PFMI quantitative disclosures, this $1.5 billion margin breach was approximately four times larger than any other breach recorded between 2015 and 2019 (Chart 3.6.1.2). MBSD took a number of steps to address backtesting deficiencies, including: (i) lowering the intraday surveillance thresholds; (ii) issuing intraday margin calls for almost $37 billion during the month of March; (iii) applying charges to members with backtesting coverage below 99 percent; and (iv) developing a plan to re-introduce a VaR floor at MBSD.
Financial Developments 119 Similar to MBSD, DTCC’s GSD clearing service also recorded large backtesting deficiencies and on March 9, 2020, GSD recorded a maximum backtesting deficiency of $797 million, which was incurred by a large dealer portfolio. According to DTCC, GSD’s backtesting deficiencies were primarily attributable to the volatility in rates markets along with changes in portfolio size or composition. Given these deficiencies, GSD applied additional margin charges to those members with backtesting coverage below 99 percent. Additionally, GSD supplemented its formal intraday margin collection with additional intraday calls.
NSCC’s VaR margin model is constructed to address dynamic changes in equity risk premiums and idiosyncratic risks that could impact equity prices. As a result, volatility charges at NSCC increased 146 percent between February and March 2020. On March 16, 2020, NSCC incurred a maximum backtesting deficiency of $318 million. To address backtesting deficiencies, NSCC made intraday margin calls totaling almost $50 billion in March and applied additional margin charges to members with backtesting coverage below 99 percent.
Derivatives CCPs The vast majority of U.S. exchange traded derivatives are cleared through CME, ICE Clear US, and the OCC. CME and ICE Clear US provide clearing services for futures and options on futures while the OCC provides clearing services for exchange-traded equity options. Within the OTC derivatives space, most USD interest rate swaps are cleared through LCH Ltd. or CME, while most credit default swaps are cleared through ICE Clear Credit, ICE Clear Europe, or LCH SA.
Derivatives CCPs generally performed as expected during the COVID-19 market stress despite the backdrop of price volatility, record volumes, and the significant operational challenges of working from home. Initial margin requirements increased significantly at derivatives CCPs beginning at the end of
120 2020 FSOC // Annual Report February, with daily increases peaking at $35 3.6.1.3 Liquidity Demand at Derivatives Clearing Organizations billion on March 9. Over the same period, there 3.6.1.3 Liquidity Demand at Derivatives Clearing Organizations was also a significant increase in daily variation Billions of US$ As Of: 30-Apr-2020 Billions of US$ 70 70 margin payments, which peaked at $54 billion Variation Margin Payments on March 9, as well (Chart 3.6.1.3). 60 Incremental Initial Margin Payments 60 50 50
The increases in initial margin requirements 40 40 were more pronounced for CCPs clearing 30 30 exchange-traded derivatives, with CME (futures and options), ICE Clear US, and the OCC 20 20 reporting a combined $131 billion increase in 10 10 required initial margin, a 72 percent increase 0 0 between the fourth quarter of 2019 and the first Feb:2020 Mar:2020 Apr:2020 Note: Light blue represents aggregate variation margin payments quarter of 2020 (Chart 3.6.1.4). Over this same and dark blue represents net initial margin payments. Series Source: CFTC covers February 3, 2020 through April 30, 2020. Excludes OCC. period, initial margin requirements for interest rate swaps at CME and LCH Ltd. increased by a combined $39 billion, or 20 percent, while initial margin requirements for credit default 3.6.1.4 Initial Margin: U.S. Exchange Traded Derivatives swaps at ICE Clear Credit, ICE Clear Europe, 3.6.1.4 Initial Margin: U.S. Exchange Traded Derivatives and LCH SA increased by $21 billion, or 46 Billions of US$ As Of: 2020 Q2 Billions of US$ 350 350 percent (Chart 3.6.1.5). The increase in initial OCC margin requirements can be attributed to both 300 ICE Clear US 300 CME the increase in derivatives activity and the 250 250 extreme volatility during this period. Initial margin requirements for exchange-traded 200 200 and OTC derivatives fell slightly in the second 150 150 quarter but remain elevated compared to 100 100 historical levels. 50 50
In the June 2020 FIA survey, respondents 0 0 2016 2017 2018 2019 2020 generally believed the industry fared well Source: ClarusFT, PFMI Note: Total initial margin required as reported in PFMI through the COVID-19 market stress, and a Quantitative Disclosures quantitative disclosures; includes house and client accounts. majority believed that post-crisis reforms helped derivatives markets cope with the pandemic. However, 76 percent of respondents identified margin volatility and unpredictability and 40 3.6.1.5 Initial Margin: OTC Derivatives 3.6.1.5 Initial Margin: OTC Derivatives percent highlighted clearing operations and Billions of US$ As Of: 2020 Q2 Billions of US$ systems as challenges needing review. 350 350
300 Credit Default Swaps 300 Interest Rate Swaps Clearing Rates for OTC Derivatives 250 250 Over the past year, the share of outstanding 200 200 OTC interest rate derivatives that were centrally cleared remained stable. Measured 150 150 by gross notional outstanding, approximately 100 100 78 percent of outstanding global interest rate 50 50 derivatives were centrally cleared as of June 0 0 2020, unchanged from June 2019. In contrast, 2016 2017 2018 2019 2020
Note: Total initial margin required as reported in PFMI quantitative the share of outstanding single- and multi- Source: ClarusFT, PFMI disclosures; includes house and client accounts. Interest rate swaps margin includes LCH Ltd. and CME. Credit default swaps margin include CME, ICC, named credit default swaps that were centrally Quantitative Disclosures ICEU, and LCH SA). CME ceased clearing credit default swaps in Mar. 2018.
Financial Developments 121 cleared increased markedly, from 54 percent 3.6.1.6 Global OTC Central Clearing Market Share 3.6.1.6 Global OTC Central Clearing Market Share as of June 2019, to 60 percent as of June 2020. Percent As Of: 2020 Q2 Trillions of US$ (Log) This increase can be attributed largely to an 100 1000 increase in the amount of multi-named CDS
80 that were centrally cleared. As of June 2020, 65 percent of multi-named CDS outstanding were 100 60 centrally cleared, up from 60 percent in June 2019. OTC equity and FX derivatives continue 40 10 to have lower clearing rates. As of June 2020, 4.1 percent of outstanding OTC FX derivatives 20 and 0.4 percent of OTC equity derivatives were
0 1 centrally cleared globally (Chart 3.6.1.6). Interest Rate FX Credit Equity
Not Cleared (left axis) Total Notional Source: BIS Cleared (left axis) Outstanding (right axis) Clearing rates in the United States were broadly similar to global clearing rates, and as of September 25, 2020, over 80 percent of outstanding OTC interest rate derivatives were centrally cleared, while 65 percent of credit 3.6.1.7 Average Clearing Rates for OTC Trading 3.6.1.7 Average Clearing Rates for OTC Trading index swaps were centrally cleared. Clearing Percent As Of: 2020 Q3 Percent rates on new U.S. interest rate swap transactions 100 100 peaked in the second quarter of 2020, when Interest Rate Swaps Credit Default Swaps over 90 percent of new U.S. interest rate swap 90 90 volumes were centrally cleared (Chart 3.6.1.7). Clearing rates on new credit index swap 80 80 transactions fell below 75 percent in the third quarter of 2020. This decline can primarily
70 70 be attributed to an increase in the volume of credit swaptions, credit total return swaps, and
60 60 other exotic credit products for which clearing 2015 2016 2017 2018 2019 2020 is not widely available, resulting in low clearing Note: Gross notional of new transactions. rates. New index CDS products that are offered Source: CFTC Excludes security-based swaps. for clearing continue to report higher clearing rates, often above 95 percent.
Central clearing has become more prevalent throughout the world as clearing mandates have been introduced in a number of jurisdictions for the most standardized products, including fixed-float rate swaps and index-based CDS. In addition, and more recently, margin requirements for uncleared swaps have led some market participants to centrally clear swaps voluntarily in cases where central clearing is more cost-efficient. As a result, clearing rates and the amount of margin posted for centrally clearable, but not mandated, products like inflation swaps and non-deliverable forwards are significantly higher than they were a few years ago, prior to the uncleared margin
122 2020 FSOC // Annual Report requirements; in some cases, these rates continued Over the same time period, the transaction volume to rise in 2020. underlying SOFR increased.
Central Clearing & Brexit In response to disruptions related to the pandemic, While lawmakers in the EU and UK have made the UK FCA, which regulates LIBOR’s administrator progress in mitigating the impact that Brexit and maintains the agreements with LIBOR panel will have on the derivatives markets and market banks for continued submissions, released a participants, the cliff-effect of the current statement reiterating the year-end 2021 target date Brexit transition period increases uncertainty for transition from LIBOR. Given that voluntary concerning how certain transactions will be agreements to continue panel bank submissions handled. Specifically, both UK-based entities and through 2021 were arranged by the UK FCA, U.S. third-country-based entities relying on UK-based regulators cannot extend or modify the timeline for personnel to support existing transactions that the transition. novate derivative contracts to EU-based affiliates would be subject to EU regulations on clearing On June 23, 2020, the UK Chancellor of the and margin requirements. Such transactions Exchequer made a statement that the UK would otherwise avoid these requirements due to government intends to propose legislation. In grandfathering provisions. particular, the UK government intends to amend the UK’s existing regulatory framework for benchmarks Currently, the relief provided by the EU does not to ensure it can be used to manage different apply to novations that occur before the end of the scenarios prior to a critical benchmark’s eventual Brexit transition period. Many EU counterparties cessation, to withstand circumstances in which the with UK-based counterparties or operations have FCA may require an administrator to change the been unwilling to novate those contracts because methodology of a critical benchmark, and to clarify the novation would trigger clearing or margin the purpose for which the FCA may exercise this requirements for the EU counterparty under power. New regulatory powers would enable the European law. Given the global nature of derivative FCA to direct a methodology change for a critical markets, such dislocations may impact U.S.-based benchmark, in circumstances where the regulator entities and markets. Derivatives markets could has found that the benchmark’s representativeness experience dislocations if neither UK nor EU will not be restored and where action is necessary authorities provide permanent relief. to protect consumers and/or to ensure market integrity. 3.6.1.2 Alternative Reference Rates In 2020, the transition from USD LIBOR continued Work of the ARRC to advance in preparation for LIBOR’s anticipated In the U.S., the Federal Reserve and FRBNY cessation after year-end 2021. Market participants, convened the ARRC to identify alternative reference index providers, vendors, the ARRC, and U.S. rates to USD LIBOR and implement an orderly and foreign regulators all took significant steps to transition plan to its recommended rate, SOFR. In address known transition issues. the last year, the ARRC made significant progress in developing contract fallback language, conventions In March, COVID-19-related market dislocations for SOFR’s use in a variety of financial instruments, caused few transactions to occur in the wholesale and best practices to facilitate the adoption of unsecured funding markets that LIBOR is designed SOFR. to measure. The lack of transactions forced LIBOR’s publication to increase reliance on expert judgment The ARRC continued to address contract robustness from LIBOR panel banks, further highlighting through the publication of recommended contract LIBOR’s vulnerabilities and the need to move fallback language for use in new issuance of forward with the LIBOR transition by year-end 2021. variable rate private student loans and updated its recommended language for bilateral business
Financial Developments 123 loans and syndicated loans. Previously, the ARRC things, proposed examples of replacement indices published recommended fallback language for other that meet Regulation Z standards. The CFTC issued asset classes, including adjustable-rate mortgages, relief from certain rules related to margin, business floating-rate notes, and securitizations. The ARRC conduct, trade execution, and clearing for legacy also identified best practices and recommended swaps referencing LIBOR that are amended as a timelines for transitioning away from USD LIBOR result of the transition. The prudential regulators across asset classes. finalized regulations for margin and capital that permitted non-cleared legacy swaps and security- In a significant step, the ARRC published its based swaps to retain their legacy status if amended spread adjustment methodology for cash products to replace an interbank offered rate. State insurance following a consultation process and began the regulators, through the NAIC, are monitoring the process of acquiring a vendor for the publication effect of the transition from LIBOR on insurer of the spread adjustment. It also began a separate derivatives positions, life insurance reserving, and acquisition process for a vendor for the potential accounting standards. Insurers will receive basis publication of a SOFR term rate. Notwithstanding swaps for some of their derivative positions as a these industry-wide transition efforts, the market result of the transition from LIBOR that may not acceptance of SOFR is progressing at various paces be permissible under most state investment laws. due to challenges such as structural differences The NAIC issued letter guidance to state insurance of SOFR vs USD LIBOR, lower liquidity in SOFR departments recommending that any basis swaps derivatives markets and cash markets, as well as received as part of the LIBOR transition be deemed various operational challenges. With respect to permissible investments under state investment laws a challenge associated with the lack of a credit for up to one year past the transition. spread, the FRBNY, FDIC, Federal Reserve, OCC, and Treasury met with representatives of a number In July 2020, the FFIEC published a “Joint Statement of U.S. regional banks to discuss ways to support on Managing the LIBOR Transition.” The joint the transition of loan products away from LIBOR, statement highlighted the risks of the transition including by holding a series of working sessions to away from LIBOR and encouraged supervised explore the development of a credit risk sensitive institutions to prepare for the transition in order to spread. The agencies involved determined the mitigate these risks. In addition to communicating official sector is not well positioned to develop a the FFIEC statement, the OCC provided additional credit-sensitive spread to SOFR, and shared a letter guidance to OCC-regulated institutions for with industry participants expressing the official identifying applicable risks, planning, and sector’s support for the continued innovation successfully transitioning from LIBOR within OCC in, and development of, suitable reference rates, Bulletin 2020-68, “FFIEC Statement on Managing including those that may have credit sensitive the Libor Transition and Guidance for Banks.” elements. Separately, in October 2020, the Financial Stability Board (FSB) published a “global transition In October 2020, the Federal Reserve issued a roadmap” that sets out a timetable of actions for supervision and regulation letter that encourages financial and non-financial sector firms to take in supervised institutions that are active in the derivatives order to ensure a smooth LIBOR transition by end- market—particularly those with large LIBOR 2021. denominated derivatives exposures—to give strong consideration to adhering to ISDA’s fallback protocol. Regulatory Actions to Facilitate Transition Council member agencies continued to monitor and In October, Treasury and the Internal Revenue Service facilitate the transition through discussions with issued guidance to provide clarification for taxpayers stakeholders and the provision of broad regulatory that modifying certain contracts to incorporate the relief. The CFPB released a notice of proposed ARRC’s and ISDA’s recommended fallback language rulemaking (NPRM) concerning the anticipated will not result in a tax realization event. discontinuation of LIBOR, including, among other
124 2020 FSOC // Annual Report On November 6, 2020, the Federal Reserve, FDIC, new instruments. Both the protocol and revised and OCC issued a statement on reference rates for definitions will go into effect on January 23, 2021. loans. The statement reiterated that agencies are not endorsing a specific replacement rate for LIBOR 3.6.2 Operational Challenges Related to COVID-19 for loans. The statement also indicated that a bank Financial institutions performed business functions may use any reference rate for its loans that the bank relatively seamlessly during the COVID-19 determines to be appropriate for its funding model pandemic, in part due to investments in operational and customer needs, and should include fallback and technology capabilities that were made prior to language in its lending contracts that provides for March. The industry also benefited from shifting use of a robust fallback rate if the initial reference customer support from in-person to online or rate is discontinued. automated processes. Banks have taken steps to protect customers and employees by consolidating Derivatives Markets branch operations and limiting walk-in traffic, The derivatives markets achieved some of the most leveraging multiple production sites to separate significant milestones toward the transition. In operational staff, and employing staggered October, two major derivative CCPs, CME and LCH, work schedules. Financial institutions have also modified the rates used in their discounting and adopted safety measures for their employees, price alignment interest methodology to replace the including transitioning to a mostly remote working effective federal funds rate with SOFR. The change environment and implementing similar protection in methodology affected approximately $120 trillion measures for the critical staff who remained onsite. notional of contracts at LCH alone, increasing exposure to SOFR and liquidity in SOFR derivatives These processes have allowed financial institutions markets. Immediately following the transition, to maintain operations while adhering to social SOFR swap volumes tripled in longer-dated tenors distancing guidelines, but also have the potential and experienced their highest rate of daily turnover. to introduce new sources of risk. For example, the Continued liquidity across the SOFR curve will be implementation of teleworking strategies using essential for a smooth transition from USD LIBOR. virtual private networks, virtual conferencing services, and other remote telecommunication Separately, on October 23, 2020, the International technologies can increase cybersecurity Swaps and Derivatives Association (ISDA) published vulnerabilities, insider risks, and other operational an updated protocol that would allow market exposures. Cyber attackers are taking advantage participants to incorporate contract fallbacks of the pandemic to create campaigns designed into legacy derivatives in the event that LIBOR to leverage individuals’ fear and uncertainty, is found by the UK FCA to be non-representative potentially increasing their rate of success of underlying market conditions or LIBOR’s under these circumstances. Ransomware is also publication ceases. Voluntary adherence to the proliferating and harming financial institutions and protocol is an important step for the smooth their third-party service providers. transition of legacy instruments in the derivatives markets. ISDA also modified its definitions to Similarly, the use of online and mobile systems incorporate the same contract fallbacks into by customers, bank staff, and third-party service providers may stress or adversely affect telecommunications capacity and management processes. Sensitive processes performed outside of institution-owned or authorized properties and devices can increase the potential for exposure of customer sensitive information.
Financial Developments 125 3.6.3.1 Market Capitalization of Blockchain-Based Digital Assets 3.6.3 Financial Innovation 3.6.3.1 Market Capitalization of Certain Blockchain-Based Digital Assets 3.6.3.1 Digital Assets and Distributed Ledger Billions of US$ As Of: 30-Sep-2020 Billions of US$ Technology 350 350 Bitcoin The market capitalization of digital assets, 300 Etherum 300 such as Bitcoin, Ethereum, XRP, and Litecoin, Ripple 250 Litecoin 250 has increased greatly in recent years though it Tether has also been highly volatile (Chart 3.6.3.1). 200 200 Data regarding the trading of digital assets is 150 150 sparse and may be unreliable. CoinMarketCap.
100 100 com estimated that after reaching $800 billion in early 2018, the market capitalization 50 50 of the digital assets that it tracks declined 0 0 precipitously to $100 billion in late 2018 2014 2015 2016 2017 2018 2019 2020 Source: Coinmarketcap.com; OFR before rising to $342 billion as of September 30, 2020. Stablecoins—digital assets designed to maintain a stable value, usually relative to another asset (typically a unit of fiat currency or commodity) or a basket of assets—continued to grow in market capitalization in 2020 following robust growth in 2019, with some experiencing a five-fold increase during that period. While the growth rate of stablecoins in 2020 has eclipsed that of other digital assets, the total market capitalizations of other types of digital assets remains substantially larger.
Digital assets are generally enabled by blockchains or other distributed ledger technologies. Such systems share data across a network, creating identical copies of their ledger that are then often stored at and synchronized across multiple locations. Distributed ledger technology has applications that extend well beyond the simple transfer of value. In recent years, an increasing number of financial institutions have initiated proof of concept or pilot projects to evaluate the potential for applications of distributed ledger technology in areas such as interbank and intrabank settlement, derivatives processing, repo clearing, and trade finance. While the ultimate value of a new technology is not always clear when it is first introduced, interest in distributed ledger technologies remains high.
126 2020 FSOC // Annual Report 3.6.3.2 Peer-to-Peer Payments firms are subject to regulations that may limit the Consumers continue to embrace peer-to-peer activities in which they engage, they are generally payment services, and the COVID-19 pandemic not subject to the same range of regulations and has further highlighted the potential benefits of oversight applicable to financial institutions. These mobile contactless payment options. Peer-to-peer technology firms can promote the development of payment services allow for the transfer of funds new products and services but could also increase between two parties using mobile apps. Some peer- risks. For example, new technology and systems to to-peer payment services have expanded capabilities evaluate and determine the creditworthiness of beyond simply facilitating transactions between potential borrowers may create benefits for financial peers, which has allowed them to, for example, institutions and customers, but may also add help facilitate government assistance payments. complexity, limit transparency, and create different The apps are typically linked to debit or credit card consumer protection risks than those of traditional accounts and other types of bank accounts, thereby credit evaluation methods if lenders do not identify allowing the funding transfers to proceed through and address potential issues in a proactive manner. bank-maintained payment networks. Although some service providers are relatively new companies, 3.6.3.5 Reliance of Financial Institutions on Third-Party banks and other financial service providers are also Service Providers entering the market and have reported significant Financial institutions are increasing their use consumer participation and transaction volume. of third-party service providers to supplement or increase their capabilities. This dynamic has 3.6.3.3 Marketplace Lending accelerated during the COVID-19 pandemic, as Marketplace lending involves the provision of loans institutions are utilizing third parties to support through online, electronic platforms. Initially, widespread remote work capabilities, increased marketplace lending focused on retail investors technological capacity, and solutions to maintain providing funding to individual borrowers and operations under elevated operational volumes. The was called peer-to-peer lending. This model has financial services industry has generally succeeded evolved into one that uses significant capital from in transitioning to a remote working environment institutional investors to finance primarily consumer without significant operational problems, to date. and small business loans. Some of the largest marketplace lenders in the consumer finance area Relationships with external providers often allow concentrate on providing debt consolidation loans an institution to take advantage of advanced or and refinancing existing student loans. During the proprietary technologies, including recent fintech COVID-19 pandemic, marketplace lenders played a innovations. Due to economies of scale or access to role in government assistance to small businesses. lower-cost labor, external providers are often able to For example, their lending platforms enabled some perform services at a lower cost than institutions can small business owners’ participation in the PPP by perform them in-house. In addition, as specialists, providing a means to apply for PPP loans. external providers may be able to perform functions for a financial institution more efficiently, more 3.6.3.4 Large Technology Firms in Financial Services accurately, or at a higher quality than if they were Prior to the pandemic, several large technology and performed internally. e-commerce firms entered, or explored entering, financial services markets. These firms offer While the use of third-party service providers can financial products or services, such as the provision have advantages, it can also introduce risk if not of loans to small businesses or individuals. Some appropriately managed. The reliance of many of these technology and e-commerce companies institutions on a single vendor creates concentration have characteristics that could allow them to grow risk, as a service interruption or cyber event at that quickly in the financial services space, including vendor could result in widespread disruption in large customer networks, broad name recognition, access to financial data and could impair the flow of and access to client data. Additionally, while these financial transactions. Third-party service providers
Financial Developments 127 may further subcontract services to other third evident in the steep increase in the premium to parties, which may make oversight more complex borrow U.S. dollars as reflected in the foreign for both the financial institution and regulatory exchange (FX) swap basis. The FX swap basis agencies. To control for risks associated with compares the cost of borrowing a currency in the outsourcing to third parties, financial institutions money market and the cost of borrowing the same should conduct appropriate due diligence before currency through an FX swap, effectively posting entering the third-party relationship and exercise foreign currency as collateral. When financial effective oversight and controls afterward. markets are operating smoothly, the FX swap basis is relatively close to zero for major currency pairs, For instance, many institutions have increased their as arbitrageurs can trade off gaps between the two. use of cloud computing services to supplement But during February and March, the FX swap basis existing data storage capacity, to provide for key U.S. dollar currency pairs spiked toward redundancy, and to gain access to additional levels last observed during 2008. As a result, foreign computational capacity. While cloud providers may banks and corporations, which were experiencing offer superior cost or technological solutions, there a surge in funding costs given the stress in CP have also been recent instances of unauthorized markets, found it more expensive to borrow against access to client data at cloud providers. As with all their currencies for dollars. The dollar shortage third-party outsourcing relationships, effective risk threatened to exacerbate liquidity strains on control is important when a financial institution corporates, contribute to widening defaults, and engages third-party cloud providers. deepen the economic downturn stemming from the pandemic. 3.7 Global Economic and Financial Developments Beginning in mid-March, the Federal Reserve took several actions to help address the strains in 3.7.1 Foreign Exchange Market dollar funding markets. First, it eased the terms As COVID-19 spread in early 2020 and financial of the swap lines with standing counterparties market strains intensified, investors sought the safety (the Bank of Canada, Bank of England, Bank of of the dollar, generating a sharp rise in the value Japan, European Central Bank, and Swiss National of the nominal trade-weighted dollar. The nominal Bank), reducing the cost of swap pricing to OIS + trade-weighted dollar appreciated 10 percent from 25 basis points, extending the maturity of the swaps the beginning of the year to its peak on March through the introduction of 84-day operations, 23—with the bulk of this move occurring in March and increasing the frequency of auctions from as countries imposed sweeping restrictions on weekly to daily. Additionally, the Federal Reserve their national economies. Among the currencies re-established temporary swap lines with nine other weakening sharply against the dollar during this central banks, including some emerging market period, the British pound depreciated 13 percent, central banks. Finally, in late March, the Federal the Australian dollar 18 percent, the Brazilian real Reserve introduced a new temporary Foreign and 22 percent, and the Mexican peso 25 percent. International Monetary Authority (FIMA) repo facility, which allowed a broader range of foreign At the same time, the premium to obtain dollar official entities to obtain dollars against U.S. funding increased to levels not seen since the Treasury collateral. Central banks immediately 2008 financial crisis. The dollar funding strains availed themselves of the swap lines to make could be primarily attributed to lenders reducing dollars available to financial institutions in their intermediation activities as a precaution amid the jurisdictions. Swaps outstanding went from under heightened uncertainty, increased demand for $50 million in early March to a peak of $449 billion dollars as some foreign banks faced significant in late May (Chart 3.7.1.1). While notable, this was drawdowns of corporate credit lines, and increased dollar hedging demand given the significant market volatility. Dollar funding strains were particularly
128 2020 FSOC // Annual Report lower than during the 2008 financial crisis, 3.7.1.1 Federal Reserve Swap Lines where the peak reached $583 billion. 3.7.1.1 Federal Reserve Swap Lines Billions of US$ As Of: 30-Sep-2020 Billions of US$ 500 500 In combination with the extraordinary actions by central banks and governments to support 400 400 the global economy, the expansion of Federal Reserve facilities helped calm dollar funding 300 300 markets. Dollar appreciation pressures eased, and the FX swap basis decreased for many 200 200 dollar currency pairs, returning to normal historical ranges by May. As strains in dollar 100 100 funding markets dissipated, outstanding 0 0 drawings on the swap lines gradually declined, Jan:20 Mar:20 May:20 Jul:20 Sep:20 falling to less than $25 billion as of September Source: Federal Reserve Note: Wednesday levels. 30, 2020.
As financial market strains eased, the sharp moves in FX rates seen in the first three months 3.7.1.2 Change in USD Exchange Rates, Advanced Economies of the year generally reversed, particularly 3.7.1.2 Change in USD Exchange Rates, Advanced Economies across advanced economies. Between March 23 Percent As Of: 30-Sep-2020 Percent and September 30, 2020, the dollar depreciated 30 30 3/23/20 – 9/30/20 Total 7.2 percent on a nominal, trade-weighted basis. 20 12/31/19 – 3/23/20 20 The euro appreciated 8.9 percent against 10 10 the dollar, the pound 12 percent, and the Australian dollar 24 percent. By September, 0 0 advanced economy currencies had appreciated -10 -10 on net against the dollar year-to-date or had -20 -20 made up nearly all of the decline from earlier -30 -30 in the year (Chart 3.7.1.2). Emerging market currencies, on the other hand, had seen Note: Percent change relative to end-2019. Positive indicates appreciation more limited recovery or had even continued Source: Federal Reserve, of listed currency. Swiss Franc (CHF), Euro (EUR), Swedish Krona (SEK), Japanese Yen (JPY), Australian Dollar, (AUD) New Zealand Dollar (NZD), to depreciate against the dollar. As of the Haver Analytics British Pound (GBP), Canadian Dollar (CAD), and Norwegian Krone (NOK). end of September, this left many emerging market currencies still substantially weaker against the dollar on net year-to-date (Chart 3.7.1.3). Continued pressures on emerging 3.7.1.3 Change in USD Exchange Rates, Emerging Markets 3.7.1.3 Change in USD Exchange Rates, EMEs market currencies have reflected in part Percent As Of: 30-Sep-2020 Percent large COVID-19 outbreaks across some major 20 20 emerging markets, combined with pre-existing 10 10 macroeconomic strains in a few specific 0 0 instances. -10 -10 While the real broad dollar index is only 0.8 percent stronger on net in 2020 through the -20 -20 3/23/20 – 9/30/20 end of September, it remains relatively strong -30 -30 12/31/19 – 3/23/20 Total from a historical perspective. Notably, the real -40 -40 trade-weighted dollar stands 8.2 percent above its 20-year average as of the end of September, Source: Federal Note: Percent change relative to end-2019. Chinese renminbi (RMB), Korean having recently peaked at its strongest level won (KRW), Indian rupee (INR), Indonesian rupiah (IDR), Mexican peso (MXN), Reserve, Wall Street South African rand (ZAR), Russian ruble (RUB), Argentine peso (ARS), Turkish Journal, Haver Analytics lira (TRY), Brazilian real (BRL). Positive indicates appreciation of listed currency.
Financial Developments 129 since 2002 (Chart 3.7.1.4). 3.7.1.4 Real U.S. Dollar Trade-Weighted Index 3.7.1.4 Real U.S. Dollar Trade-Weighted Index Index As Of: Sep-2020 Index 3.7.2 Advanced Economies 120 120 The COVID-19 pandemic has led to a dramatic decline in global economic activity. According 110 110 to the International Monetary Fund (IMF) October 2020 World Economic Outlook 100 100 (WEO), advanced economies are projected to contract by 5.8 percent in 2020. Despite the 90 90 steep decline in U.S. economic activity, the U.S. is projected to outperform other advanced 80 80 economies, with real GDP projected to decline 2000 2003 2006 2009 2012 2015 2018 Note: Index shown as a share of its 20-year average. Real USD by 4.3 percent in 2020. In comparison, real GDP Source: Federal Reserve, Trade-Weighted Index is a weighted average of the FX value of the USD against the currencies of a broad group of major U.S. in the euro area, the United Kingdom (UK), Haver Analytics trading partners. Gray bars signify NBER recessions. and Japan is projected to decline by 8.3 percent, 9.8 percent, and 5.3 percent, respectively (Chart 3.7.2.1). Real GDP for advanced economies is projected to rebound sharply in 2021, but remain 3.7.2.1 Advanced Economies Real GDP Growth 3.7.2.1 Advanced Economies Real GDP Growth below its 2019 level. The rapidly evolving nature Percent As Of: Oct-2020 Percent of the pandemic, however, introduces significant 8 8 uncertainty into any forecast, and the depth and duration of the contraction is dependent on 4 4 a number of factors, most notably authorities’
0 0 ability to limit the spread of COVID-19 without imposing lockdown measures, the development -4 -4 of a vaccine and therapeutics, and fiscal and United States monetary economic support. United Kingdom -8 -8 Euro Area Japan Advanced economies have taken significant -12 -12 2005 2007 2009 2011 2013 2015 2017 2019 2021 fiscal measures to help mitigate the impact of Source: IMF WEO, Note: Annual change in GDP, constant prices. Dotted lines COVID-19 and support long-term economic Haver Analytics represent the IMF’s most recent projections for 2020 and 2021. recovery. They have relied on a combination of direct fiscal stimulus programs, such as wage subsidies and cash payments, along with liquidity support in the form of loans, 3.7.2.2 General Government Gross Debt to GDP asset purchases, and guarantees. Direct fiscal 3.7.2.2 General Government Gross Debt to GDP spending programs have increased headline Percent Percent 300 300 government debt levels meaningfully in 2020
2020 (October 2020 Projection) (Chart 3.7.2.2). In contrast, liquidity support 250 250 2019 is largely off-balance sheet and could lead to 200 200 significant growth in government debt if these public interventions incur losses. 150 150
100 100 In 2019, negative interest rate policies, coupled
50 50 with increased economic uncertainty, pushed the amount of negative-yielding debt in the 0 0 United Germany France Italy Spain Japan United Bloomberg Barclays Global Aggregate Negative States Kingdom Yielding Debt Index up significantly, hitting Source: IMF WEO a record $17 trillion in August 2019 (Chart
130 2020 FSOC // Annual Report 3.7.2.3). While the amount outstanding in the 3.7.2.3 Outstanding Negative Yielding Debt index declined in the months following, the 3.7.2.3 Outstanding Negative Yielding Debt value of negative-yielding debt represented by Trillions of US$ As Of: 30-Sep-2020 Trillions of US$ 20 20 the index remained well above historical levels. Government Related Corporates During the March 2020 market stress, however, Sovereigns Securitized the index value of negative-yielding debt fell 15 15 sharply to less than $8 trillion. Since then, the index value of negative-yielding debt has 10 10 steadily risen, and by the end of September, the amount outstanding again reached $16 trillion, 5 5 slightly below the August 2019 record.
0 0 2017 2018 2019 2020 Euro Area Note: Market value of Bloomberg Barclays Global Aggregate Negative Yielding Debt Index, which is a sub-index of the Bloomberg Barclays Even prior to the COVID-19 pandemic, Aggregate Index. In 2017, SIFMA estimated that the aggregate index Source: Bloomberg, L.P. covers approximately half of the value of global bonds outstanding. the economic outlook in the euro area was deteriorating. In the fourth quarter of 2019, euro area real GDP growth was flat, industrial confidence had fallen to its lowest level since 3.7.2.4 Euro Area H1 2020 Real GDP 2013, and inflation expectations were at record 3.7.2.4 Euro Area H1 2020 Real GDP lows. While economic data improved somewhat Percent As Of: 2020 Q2 Percent in January and February 2020, economic 10 10 activity collapsed in March as COVID-19 spread through Europe, and major European 0 0 Union (EU) member states imposed national lockdown policies. Euro area GDP growth fell by -10 -10 a cumulative rate of 15 percent in the first half of 2020 (Chart 3.7.2.4). The decline in GDP -20 -20 was particularly pronounced in economies that imposed severe measures to control widespread -30 -30 outbreaks, with Spanish, French, and Italian
GDP falling by 22 percent, 19 percent, and 18 Note: Percentage change in real GDP Q2 2020 percent, respectively. Source: Eurostat, Haver Analytics compared with Q4 2019. Seasonally adjusted.
Euro area economic activity rebounded considerably in the summer, and in the third quarter of 2020, euro area real GDP increased 3.7.2.5 Euro Area Business and Consumer Surveys 3.7.2.5 Euro Area Business and Consumer Surveys by nearly 13 percent compared to the previous Percent As Of: Sep-2020 Index quarter. Despite this rebound, economic 20 120 sentiment remained below pre-pandemic 10 110 levels through September 2020, and the recent resurgence of COVID-19 cases and partial 0 100 reimposition of national lockdowns will likely -10 90 weigh on the economic recovery going forward -20 80 (Chart 3.7.2.5). Economic Sentiment (right axis) -30 Industrial Confidence (left axis) 70 Consumer Confidence (left axis) To help limit the economic impact of -40 60 COVID-19, the ECB deployed a range 2006 2009 2012 2015 2018 Note: Confidence surveys calculated by subtracting of unconventional monetary tools while Source: European Commission, the percentage of negative responses from the percentage of favorable responses. For economic maintaining its deposit rate at -0.5 percent. Haver Analytics sentiment index, 100 = long-term average.
Financial Developments 131 Among other programs, the ECB launched a and digital transitions. While the plan has yet to be further round of asset purchases under its Pandemic ratified by national parliaments, it is expected that Emergency Purchase Programme (PEPP). The the majority of resources will be allocated between PEPP supplements the ECB’s Asset Purchase 2021 and 2023 and that the maximum volume of Programme (APP) and allows the ECB to purchase the loans for each member state will not exceed 6.8 assets currently eligible under the APP along with percent of its gross national income. Greek government debt and nonfinancial CP. As of September 30, 2020, the ECB had purchased €567 At the national level, euro area member states have billion of securities under PEPP and is expected to also instituted a broad set of fiscal measures to purchase a further €783 billion through June 2021. help mitigate the direct economic impact of the Additionally, the ECB eased conditions for its third COVID-19 pandemic. Importantly, several euro series of targeted long-term refinancing operations area economies have implemented job retention (TLTRO III) and new series of pandemic emergency schemes in order to limit households’ loss of income longer-term refinancing operations. Participation and firms’ wage costs during the pandemic. In in TLTRO III has been robust, and the amount of addition, euro area member states have supported funds allotted in June and September 2020 totaled businesses through loan guarantee programs and a combined €1.5 trillion, up from €0.2 trillion in have introduced active tax and spending measures March 2020. to support the recovery.
In addition, the ECB has introduced a range of As of the end of the second quarter of 2020, the supervisory measures in response to COVID-19. euro area general government debt totaled €11 First, the ECB provided capital relief measures, trillion, up from €10 as of the second quarter of which are estimated to temporarily free up 2019. Within the euro area, Italian, French, and roughly €120 billion of CET1 capital. The ECB German debt outstanding totaled €2.5 trillion, has also provided supervisory flexibility regarding €2.6 trillion, and €2.3 trillion, respectively, or 149 the treatment of non-performing loans (NPLs), percent, 114 percent, and 67 percent of GDP. Debt provided guidance to limit the procyclical effects outstanding for all euro area economies is projected of loss provisioning under International Financial to rise in the coming quarters as fiscal relief efforts Reporting Standards (IFRS) 9, and recommended to tackle COVID-19 take hold. that banks refrain from making dividends payments until 2021. In combination, these countercyclical measures could act as shock absorbers and mitigate the tightening of financing conditions for households and businesses.
On the fiscal front, the EU announced a historic plan to help aid member states’ economic recovery from COVID-19. The recovery plan, which was agreed upon by EU leaders on July 21, 2020, permits the European Commission to borrow up to €750 billion on behalf of member states. Of this amount, €390 billion would be dispersed as grants, while the remaining €360 billion would be dispersed as loans. The plan should provide heavily indebted member states additional fiscal space to support economic recovery from the COVID-19 pandemic. To participate, member states must prepare national recovery and resilience plans, and a large portion of the funds is expected to support investment in green
132 2020 FSOC // Annual Report Yields on European sovereign bonds, which fell 3.7.2.6 Euro Area 10-Year Sovereign Yields to record lows in mid-2019, rose slightly in late 3.7.2.6 Euro Area 10-Year Sovereign Yields 2019 and early 2020 (Chart 3.7.2.6). However, Percent As Of: 30-Sep-2020 Percent 5 5 during the March 2020 market stress, yields Italy Spain 4 4 on highly-rated European sovereign bonds France plunged again, and by mid-March, the 10- Germany 3 3 year German bond (Bund) fell to a record -84 basis points. At the same time, spreads across 2 2 European sovereigns widened. Beginning in 1 1 late February, the spread between Italian (BTP) and Bund yields widened as investors grew 0 0 concerned about the outbreak in northern Italy -1 -1 (Chart 3.7.2.7). The spread between BTPs and Jan:2015 Jan:2016 Jan:2017 Jan:2018 Jan:2019 Jan:2020 Bunds topped out at around 2.8 percent in Source: Reuters, Haver Analytics mid-March and has since more than retraced its gains following the ECB’s launch of PEPP and the announcement of the EU-wide fiscal relief package. 3.7.2.7 Euro Area 10-Year Spreads 3.7.2.7 Euro Area 10-Year Spreads United Kingdom Percent As Of: 30-Sep-2020 Percent On January 31, 2020, the UK officially exited 5 20 Italy (left axis) Greece (right axis) the EU under the Withdrawal Agreement. As Spain (left axis) Ireland (left axis) 4 16 part of the Withdrawal Agreement, the UK France (left axis) Portugal (left axis) and EU agreed to a transition period until 3 12 December 31, 2020, during which the UK is not in the EU but retains all of the rights and 2 8 obligations of an EU member. While the focus has since shifted to handling the COVID-19 1 4 pandemic, the post-Brexit transition period has 0 0 not been extended and, absent any agreement, 2015 2016 2017 2018 2019 2020 UK-EU trade will revert to World Trade Note: Calculated as the weekly average Organization rules at year-end. Source: Reuters, Haver Analytics spread between local 10Y and German 10Y.
Similar to other European countries, the UK was severely impacted by COVID-19. UK GDP fell by a cumulative 21 percent in the first half of 2020, rivaling Spain as the economy most negatively impacted by the pandemic. To help keep workers employed during the COVID-19 related lockdowns, the UK government instituted a policy to cover 80 percent of furloughed workers’ monthly salaries up to a ceiling. Given that furloughed workers are considered employed, the UK unemployment rate has remained relatively stable and was reported at 4.8 percent between July and September 2020.
Financial Developments 133 3.7.2.8 UK COVID-19 Business Loan Schemes At the same time, the UK government has 3.7.2.8 UK COVID-19 Business Loan Schemes launched three separate loan schemes to Billions of GBP As Of: 18-Oct-2020 Billions of GBP 70 70 facilitate businesses’ access to credit (Chart CLBILS 3.7.2.8). The Bounce Back Loan Scheme is 60 CBILS 60 BBLS aimed at micro businesses and includes a 50 50 100 percent government guarantee, while 40 40 the Coronavirus Business Interruption Loan
30 30 Scheme and Coronavirus Large Business Interruption Loan Scheme, which are aimed 20 20 at small and medium-sized enterprises (SMEs) 10 10 and larger businesses, are backed by an 80 0 0 percent government guarantee. As of October May:2020 Jun:2020 Jul:2020 Aug:2020 Sep:2020 Oct:2020 Note: Bounce Back Loan Scheme (BBLS), Coronavirus Large 18, aggregate lending under these three Business Interruption Loan Scheme (CLBILS), Coronavirus Business Interruption Loan Scheme (CBILS). Data reported schemes totaled £62 billion. Source: HM Treasury monthly instead of weekly after August 16, 2020.
The Bank of England (BOE) has also introduced a range of measures to respond to the economic shock from COVID-19. On March 3.7.2.9 Japanese Consumer Price Inflation 3.7.2.9 Japanese Consumer Price Inflation 10, the BoE Monetary Policy Committee voted Percent As Of: Sep-2020 Percent to reduce its bank rate from 75 basis points to 3 3 25 basis points and to introduce a new Term 2 2 Funding Scheme with additional incentives for
1 1 SMEs, financed by the issuance of central bank reserves. In addition, the BOE Financial Policy 0 0 Committee reduced the UK countercyclical
-1 -1 capital buffer rate to 0 percent and the BOE Prudential Regulation Authority set out its -2 -2 supervisory expectation that banks should not -3 -3 increase dividends or other distributions, such 2005 2008 2011 2014 2017 2020 as bonuses. Note: Data represents year-over-year percentage Source: Bank of Japan, change. CPI excludes fresh food and is adjusted for the Haver Analytics consumption tax increase that took effect in April 2014. Japan Japanese economic activity fell significantly due to COVID-19 related lockdowns. In the third quarter of 2020, Japanese real GDP fell by 5.9 percent compared to the third quarter of 2019. Between 2017 and 2019, inflation in Japan remained positive but has since turned negative and stood at -0.7 percent as of September 30, 2020 (Chart 3.7.2.9).
Prior to the pandemic, the Bank of Japan (BOJ) eased its monetary stance by switching from an outcome-based forward guidance policy to an open-ended policy, noting that it expected to keep policy rates at current levels or to reduce them so long as uncertainties remained regarding reaching the 2 percent inflation target. The BOJ has maintained its policy rate
134 2020 FSOC // Annual Report at -0.1 percent since January 2016. In addition, 3.7.2.10 Japan 10-Year Government Bond Yield the BOJ continued to follow its policy of yield 3.7.2.10 Japan 10-Year Government Bond Yield curve control whereby the BOJ will purchase Basis Points As Of: 30-Sep-2020 Basis Points JGBs so that the 10-year JGB yield remains at 160 160 around zero percent. Since the introduction of 120 120 the BOJ’s yield curve control policy in 2016, the yield on 10-year JGBs has been little changed 80 80 (Chart 3.7.2.10).
40 40 On March 26, 2020, the BOJ announced that it would enhance monetary easing through 0 0 a number of policy measures, including -40 -40 increasing purchases of Japanese government 2010 2012 2014 2016 2018 2020 bonds (JGBs), easing access to U.S. dollar Source: Bloomberg, L.P. funds, purchasing CP and corporate bonds, establishing a new operation to provide loans against corporate debt, and by actively purchasing exchange-traded funds and Japanese REITs.
At subsequent meetings, the BOJ announced the expansion of its CP and corporate bond purchase programs along with the introduction of a new operation to support bank lending to SMEs. In total, the BOJ’s COVID-19 support programs amount to ¥110 trillion, or approximately $1 trillion. Of this amount, ¥20 trillion is in the form of CP and corporate bond buying programs while the remaining ¥90 trillion is in the form of lending programs.
In addition to the BOJ’s monetary response, the Japanese Financial Services Agency (JFSA) has provided guidance with regard to bank capital requirements in light of the COVID-19 pandemic. Specifically, the JFSA confirmed that banks can use capital buffers when necessary to maintain lending volume. The JFSA has also confirmed that certain rescue lending activity would be risk weighted at 0 percent, that it would take a flexible approach to banks breaching the liquidity coverage ratio, and that the JFSA and BOJ would temporarily exclude central bank deposits from the leverage ratio exposure measure. Finally, the Japanese government announced a series of fiscal packages to support its economy, including cash handouts to individuals, subsidies to affected
Financial Developments 135 firms, and the introduction of loan guarantee 3.7.3.1 2020 Real GDP Revisions for Developing Economies 3.7.3.1 2020 Real GDP Revisions for Developing Economies programs. Percent Percent 12 12 3.7.3 Emerging Market and Developing October 2020 IMF Forecast 8 October 2019 IMF Forecast 8 Economies Similar to advanced economies, EMEs 4 4 experienced a sharp contraction in economic 0 0 output in the first half of 2020. According
-4 -4 to the IMF’s October 2020 WEO update, emerging and developing economies, which -8 -8 were projected to grow by approximately 4.6
-12 -12 percent in 2020, are now projected to contract Aggregate EM Asia EM Europe Latin Middle East Sub- America & Central Saharan by 3.3 percent (Chart 3.7.3.1). Latin American Asia Africa Source: IMF WEO economies, which are sensitive to commodity price fluctuations and have been hard hit by the COVID-19 pandemic, are projected to contract by 8.1 percent in 2020. In aggregate, emerging Asian economies have had more success in 3.7.3.2 COVID-19 Impact on 2020 Current Account Balances 3.7.3.2 COVID-19 Impact on 2020 Current Account Balances containing the spread of COVID-19, permitting Percent of GDP Percent of GDP authorities to lift lockdowns relatively quickly. 8 8 Comparatively, emerging Asian economies are Net Impact Oil Effect projected to contract by 1.7 percent in 2020. 4 4 Tourism & Remittances In the years following the 2013 Taper Tantrum, 0 0 most EMEs narrowed current account deficits and built up reserves. Nevertheless, certain -4 -4 EMEs remained vulnerable to external shocks, and those reliant on remittances, tourism, or -8 -8 higher commodity prices are likely to see a ZAF THA PAK POL TUR SAU PER BRA COL RUS EGY CHN ARG KOR MYS MEX deterioration in their external balances (Chart
Source: IMF July 2020 Note: Estimated net direct impact of specific factors 3.7.3.2). Additionally, EMEs typically have less External Sector Report on current account balances for select EMEs. fiscal capacity relative to advanced economies to respond to the economic fallout associated with the COVID-19 pandemic, complicating both the health response and the economic recovery. 3.7.3.3 Emerging Market Sovereign Bond Spreads 3.7.3.3 Emerging Market Sovereign Bond Spreads Basis Points As Of: 30-Sep-2020 Basis Points 1000 1000 Spreads on USD-denominated sovereign bonds Latin America Europe in all emerging market regions spiked sharply 800 800 Asia in March 2020 as investors repriced risk assets given the dimming global economic outlook 600 600 (Chart 3.7.3.3). Latin American spreads
400 400 surged to 800 basis points, while spreads for emerging Asia and emerging Europe 200 200 roughly doubled to 340 basis points and 580 basis points, respectively. Spreads on USD- 0 0 2013 2014 2015 2016 2017 2018 2019 2020 denominated bonds have since compressed Note: JP Morgan EMBI+ Sovereign as foreign investor capital outflows subsided Source: JP Morgan, Haver Analytics Spreads indices for each region. amid improved investor sentiment, in part due
136 2020 FSOC // Annual Report to aggressive policy responses and optimism 3.7.3.4 Foreign Investor Capital Inflows to EMEs around the development of a COVID-19 vaccine 3.7.3.4 Foreign Investor Capital Inflows to EMEs and treatment methods, as well as expectations Billions of US$ As Of: 2020 Q2 Billions of US$ that full-scale lockdowns may be avoided. At 500 500 the same time, local currency bond spreads 375 375 have also compressed amid the launch of local currency bond purchase programs by 250 250 some emerging market central banks aimed at 125 125 providing liquidity and supporting local bond markets. Despite this compression in spreads, 0 0 the outlook for emerging market credit has -125 -125 Portfolio Inflows Net Flows deteriorated over the past year, and Fitch Foreign Direct Investment Bank Inflows downgraded a record number of sovereigns in -250 -250 2010 2012 2014 2016 2018 2020 the first half of 2020. Source: IMF, Haver Analytics
While net capital flows to EMEs remained positive in the first quarter of 2020, portfolio flows turned negative for the first time since 3.7.3.5 Foreign Investor Portfolio Inflows to EMEs 2015 (Chart 3.7.3.4). During this period, EMEs 3.7.3.5 Foreign Investor Portfolio Inflows to EMEs witnessed over $50 billion of equity portfolio Billions of US$ As Of: 2020 Q2 Billions of US$ outflows, the largest recorded quarterly 200 200 outflow in over 15 years, with China and Korea Debt Inflows Net Portfolio Flows 150 Equity Inflows 150 accounting for nearly half (Chart 3.7.3.5). In aggregate, equity flows stabilized in the second 100 100 quarter of 2020, which can largely be attributed 50 50 to sizable inflows into China. Foreign direct investment (FDI) and bank flows, which tend 0 0 to be less volatile, remained positive in the -50 -50 first quarter of 2020 at $116 billion and $84 billion, respectively. While EMEs continued to -100 -100 2010 2012 2014 2016 2018 2020 see robust FDI inflows in the second quarter of 2020, bank inflows fell to $5 billion, as Brazil Source: IMF, Haver Analytics reported large bank outflows.
Low-Income Countries The G20 and other organizations took action to relieve credit stress on low-income countries in response to the COVID-19 crisis. In May 2020, the G20 and Paris Club initiated the Debt Service Suspension Initiative (DSSI), whereby official bilateral creditors were encouraged to postpone debt service payments to eligible low-income countries through the end of 2020. In October, the G20 and Paris Club extended the DSSI through June 2021, with possible extensions through the end of 2021. As of September 30, 2020, 43 countries have requested forbearance under the DSSI, freeing up $5 billion in fiscal space to fund social,
Financial Developments 137 health, and economic measures to respond 3.7.3.6 Chinese Overseas Lending 3.7.3.6 Chinese Overseas Lending to the pandemic. Additionally, the IMF has Billions of US$ As Of: 2019 Billions of US$ doubled access to its emergency financing 1750 1750 FDI (Debt) facilities, allowing it to meet increased demand 1500 Trade Credit 1500 for financial assistance during the pandemic. Loans 1250 1250 These measures should help support low- income countries that do not have access to 1000 1000 the same monetary and fiscal policy tools as 750 750 advanced economies. Nevertheless, additional 500 500 debt relief measures may be necessary, and any
250 250 restructuring could be complicated due to the increasing reliance on non-Paris Club creditors. 0 0 2004 2007 2010 2013 2016 2019 Source: State Administration of Note: FDI (Debt) reported Over the past decade, non-Paris Club creditors Foreign Exchange, Haver Analytics from 2011 onwards. have become a significant source of external financing for low-income countries. In particular, China has significantly increased overseas lending as part of its Belt and Road Initiative. According to the People’s Bank of China (PBOC), Chinese overseas lending in the form of direct loans, trade credit, and FDI debt exceeded $1.5 trillion as of year-end 2019 (Chart 3.7.3.6). However, there is limited transparency regarding the destination and terms of Chinese overseas lending, and the actual amount of lending may significantly exceed what is reported. While China has agreed to participate in the G20’s temporary DSSI, the full scope of participation in unclear. For example, China has not suspended debt payments due to China Development Bank (CDB) as part of the official sector DSSI, instead classifying CDB as a commercial creditor. The lack of transparency on Chinese overseas lending and on its participation in the current DSSI potentially complicates any future debt relief initiatives.
At the same time, low-income countries have increasingly relied on commercial creditors as a source of financing via the Eurobond market. According to the IMF, the issuance of foreign currency-denominated bonds by low-income countries has almost tripled from an average of $6 billion between 2012 and 2016 to an average of $16 billion between 2017 and 2018. While the G20 has called upon private creditors to participate in debt relief efforts, private sector participation has been limited.
138 2020 FSOC // Annual Report China 3.7.3.7 Chinese Real GDP Growth and its Components In response to the COVID-19 outbreak, 3.7.3.7 Chinese Real GDP Growth and its Components Chinese authorities imposed strict containment Percent As Of: 2020 Q3 Percent 20 20 measures, which led to a sharp drop in Manufacturing economic activity. Chinese economic growth, 15 15 which has been slowing in recent years, 10 Services 10 contracted by 6.8 percent year-over-year in the Total first quarter of 2020 (Chart 3.7.3.7). To support 5 5 the Chinese economy through the COVID-19 Agriculture 0 0 pandemic, the Chinese government announced RMB 4.6 trillion of discretionary fiscal -5 -5 spending, worth roughly 5 percent of GDP. -10 -10 Concurrently, the PBOC provided moderate 2005 2008 2011 2014 2017 2020 stimulus and acted to safeguard financial Source: China National Bureau of Statistics, Haver Analytics Note: Year-over-year percentage change. market stability.
In mid-February, Chinese authorities began to lift strict lockdown measures outside of 3.7.3.8 Credit to the Chinese Nonfinancial Private Sector Hubei Province, and by the third quarter 3.7.3.8 Credit to the Chinese Nonfinancial Private Sector of 2020, real GDP growth rebounded to 4.9 Percent of GDP As Of: 2020 Q1 Percent of GDP percent year-over-year. Despite the robust 240 Nonbank Lending rebound in Chinese manufacturing, the 200 Bank Lending domestic consumption recovery was muted, and household consumption remained below pre- 160 pandemic levels. 120
Prior to the COVID-19 pandemic, Chinese 80 authorities were taking steps to encourage 40 financial deleveraging, leading to a stabilization in the level of credit provided to 0 0 2008 2010 2012 2014 2016 2018 2020 the nonfinancial private sector as a percent of Source: China National Bureau of GDP. Nevertheless, the stock of nonfinancial Statistics, BIS, Haver Analytics Note: Rolling 4-quarter sum of GDP. private sector debt continued to increase and nonfinancial debt remained above 200 percent of GDP as of the fourth quarter of 2019 (Chart 3.7.3.8). In 2020, Chinese regulators paused 3.7.3.9 Chinese Credit Growth 3.7.3.9 Chinese Credit Growth their deleveraging campaign as authorities try Percent As Of: Sep-2020 Percent to balance COVID-19 related credit support 25 25 Total Social Financing (New Definition) with longer-term financial stability goals. As a Total Social Financing (Old Definition) result, Chinese credit growth, which had been 20 20 trending downward in recent years, accelerated considerably between March and September 15 15 2020 (Chart 3.7.3.9). A significant portion of recent credit growth may be attributed to 10 10 authorities calling on commercial banks to 5 5 forgo upwards of RMB 1.5 trillion in profits in 2013 2014 2015 2016 2017 2018 2019 2020
2020 to support firms and the real economy Note: Calculated as the year-over-year percentage change in total Source: PBOC, CCDC, social financing (TSF) flows since 2002. TSF refers to the total volume by offering lower lending rates, cutting fees, of financing provided by the financial system to the real economy. TSF Haver Analytics, Staff (old definition) excludes loan write-offs, ABS of depository institutions, deferring loan repayments, and granting more Calculations and local government special bonds.
Financial Developments 139 unsecured loans. Additionally, the cut in reserve In May 2020, Chinese authorities introduced a requirements and a seeming commitment by the national security law for Hong Kong in an attempt PBOC to provide liquidity may be helping banks to to quell anti-government protests. The law, which boost lending. At the same time, the government was passed by the National People’s Congress in is supporting small and midsize banks to replenish June, bypasses Hong Kong’s Legislative Council their capital through various channels, including and criminalizes any act of secession, subversion, issuing ordinary shares, preferred shares, and terrorism, or collusion with foreign or external perpetual bonds, in addition to the new special local forces. The broad nature of the National Security government bonds. Law gives Beijing additional control over Hong Kong’s judicial system, eroding the city’s rule of law, Prior to the COVID-19 pandemic, the official NPL and threatens the city’s status as a global financial ratio at Chinese commercial banks stood at 1.9 center. percent, although many market observers believe that the true NPL ratio was materially higher. Relief While the Hong Kong dollar initially came under efforts to help support SMEs during the COVID-19 pressure in the forward markets, fears of significant pandemic may have further exacerbated any capital outflows have not materialized, as investors underreporting of NPLs as current rules allow banks are still assessing the impact of the National Security to book interest payments even though the loans Law. Instead, possibly at the direction of Chinese were in forbearance. Consequently, the aggregate authorities, inflows from mainland investors into NPL ratio for Chinese commercial banks is little Hong Kong equity markets have supported financial changed through the second quarter of 2020. markets, and the Hong Kong dollar has been trading at the strong end of its trading band in In June 2020, Chinese authorities stated that they recent months. will accelerate the settlement of NPLs in the second half of 2020, urging banks to make a bona fide classification of their assets. At the same time, China Banking and Insurance Regulatory Commission authorities stated that some small- and medium- sized financial institutions are facing deteriorating asset quality and NPLs are estimated to increase by approximately 50 percent by year-end. Chinese central authorities will also allow local governments to recapitalize small and medium banks by issuing new special local government bonds.
On January 15, 2020, the United States and China signed the Phase One trade agreement, whereby China agreed to increase purchases of American products and services in 2020 and 2021 by at least $200 billion above 2017 levels, and the United States agreed to lower some tariffs on Chinese goods. In addition, China committed to provide improved access to China’s financial services market for U.S. companies and provide stronger legal protections for U.S. companies operating in China, particularly concerning intellectual property rights and technology transfer.
140 2020 FSOC // Annual Report Council Activities and 4 Regulatory Developments 4.1 Select Policy Responses to Support to use its full range of tools to support the flow of credit the Economy to households and businesses in support of its policy mandates. In addition, the FOMC engaged in Treasury As parts of the economy shut down and stress and agency MBS purchases to support smooth market spread through financial markets, policymakers functioning. acted to minimize the health and economic effects of the pandemic. Liquidity Facilities and Programs To address the liquidity squeeze associated with CARES Act investors’ shift to cash and liquid assets, the Federal On March 27, the CARES Act was signed Reserve established liquidity facilities and programs into law. The CARES Act authorized over $2 under section 13(3) of the Federal Reserve Act, with trillion to address COVID-19 and to support Treasury’s approval. the economy, households, businesses, and other entities. The CARES Act supported businesses On March 17, the Federal Reserve announced the through programs such as the PPP, which establishment of the Commercial Paper Funding Facility provides a direct incentive for small businesses (CPFF) to ensure the functioning of the commercial to keep their workers on the payroll, along paper market so that a broad range of companies with significant additional funding for existing would have access to credit and funding to meet their loan programs. The CARES Act also supported operational needs. Treasury provided $10 billion of households and businesses through expanded credit protection to the Federal Reserve. The CPFF is unemployment benefits, cash payments to scheduled to expire on March 17, 2021. certain eligible households, several types of tax relief, forbearance for certain homeowners, Also on March 17, the Federal Reserve announced the and foreclosure and evictions moratoria for establishment of the Primary Dealer Credit Facility certain households. The statute also provided (PDCF) to offer overnight and term funding to primary financial assistance to airlines and related dealers so that they may support market functioning and firms and businesses critical to maintaining facilitate credit availability. The PDCF is scheduled to national security; financial regulatory relief for expire on December 31, 2020. community banks and certain other financial institutions; and appropriated $454 billion On March 18, the Federal Reserve announced the to Treasury to support certain facilities and establishment of the MMLF to support market programs established by the Federal Reserve. In functioning and credit provision to the economy by addition, the CARES Act provided significant helping money market funds meet redemption demands funding for state and local governments and by investors. The Treasury Department provided $10 health care providers. billion of credit protection to the Federal Reserve. The MMLF is scheduled to expire on December 31, 2020. Monetary Policy The FOMC lowered rates on March 3 and again On April 9, the Federal Reserve announced the on March 15 to the current level close to zero. establishment of the Municipal Liquidity Facility (MLF) The FOMC stated that it would keep rates low to assist eligible state and local governments manage until it was confident that the economy had cash flow issues by offering up to $500 billion in lending. weathered recent events and was on track to Treasury provided $35 billion of credit protection to achieve its maximum employment and price the Federal Reserve. The MLF is scheduled to expire on stability goals. It also stated that it was prepared December 31, 2020.
Council Activities and Regulatory Developments 141 Credit Market Facilities and Programs Reserve for the MSLP. The facilities are scheduled to The Federal Reserve also established several expire on December 31, 2020. facilities and programs under section 13(3) of the Federal Reserve Act to ensure the flow of credit to Offshore Dollar Funding Markets households, nonprofits, and businesses. The Federal Reserve also acted to provide liquidity to offshore dollar funding markets that were under On March 23, the Federal Reserve announced the stress. establishment of the Term Asset-Backed Securities Loan Facility (TALF) to support the flow of credit On March 15, the Federal Reserve, in coordination by enabling the issuance of asset-backed securities with the Bank of Canada, Bank of England, Bank backed by certain types of loans. Treasury provided of Japan, the European Central Bank, and the Swiss $10 billion of credit protection to the Federal National Bank, announced two changes to enhance Reserve. The TALF is scheduled to expire on standing U.S. dollar swap arrangements: pricing was December 31, 2020. lowered to OIS +25 basis points and 84-day maturity auctions commenced. On March 23, the Federal Reserve also announced the establishment of the Primary Market Corporate On March 19, the Federal Reserve announced the Credit Facility (PMCCF) and the Secondary Market establishment of temporary U.S. dollar liquidity Corporate Credit Facility (SMCCF). The PMCCF arrangements with the Reserve Bank of Australia, supports credit to larger employers for bond the Banco Central do Brasil, the Danmarks and syndicated loan issuance, and the SMCCF Nationalbank (Denmark), the Bank of Korea, the supports credit to large employers by supporting Banco de Mexico, the Norges Bank (Norway), liquidity for outstanding corporate bonds. Both the Reserve Bank of New Zealand, the Monetary facilities were initially open to investment grade Authority of Singapore, and the Sveriges Riksbank companies and, on April 9, extended to include (Sweden). Like the existing arrangements with certain high-yield, rated companies that were other central banks, the facilities help address investment grade as of March 22, 2020. Treasury strains in global U.S. dollar funding markets. provided $50 billion of credit protection to the Federal Reserve for the PMCCF and $25 billion for On March 20, the Federal Reserve, again in the SMCCF. Both facilities are scheduled to expire coordination with the Bank of Canada, Bank of on December 31, 2020. England, Bank of Japan, the European Central Bank, and the Swiss National Bank, announced that On April 9, the Federal Reserve announced one-week swaps would be offered daily. the establishment of the Paycheck Protection Program Lending Facility (PPPLF) to increase the On March 31, the Federal Reserve announced the effectiveness of the SBA’s PPP by supplying liquidity establishment of the temporary FIMA Repo Facility. to financial institutions participating in PPP. The The FIMA Repo Facility allows certain central banks PPPLF extends credit to eligible financial institutions and other international monetary authorities to that pledge PPP loans as collateral. The PPPLF is enter into repurchase agreements with the Federal scheduled to expire on December 31, 2020. Reserve. In addition to supporting global U.S. dollar funding markets, the facility is intended to support On April 9, the Federal Reserve also announced the the smooth functioning of the U.S. Treasury market establishment of the Main Street Lending Program by offering an alternative source of U.S. dollars to (MSLP) to support lending to small and medium- sales of Treasury securities in the open market. sized businesses. The Federal Reserve expanded the MSLP to include nonprofits in July. The MSLP Federal Reserve Balance Sheet operates through five facilities. Treasury provided As a result of its policy actions, the Federal Reserve’s $75 billion in credit protection to the Federal balance sheet has increased significantly, totaling over $7 trillion in assets as of September 30, 2020
142 2020 FSOC // Annual Report (Chart 4.1.1). Most of the increase in 2020 4.1.1 Total Assets of the Federal Reserve is due to its Treasury and MBS purchases. 4.1.1 Total Assets of the Federal Reserve After peaking at approximately $130 billion Trillions of US$ As Of: 30-Sep-2020 Trillions of US$ 8 8 early in the crisis, the Federal Reserve’s purchases in support of its liquidity and credit 7 7 facilities were approximately $100 billion 6 6 as of September 1, 2020 (Chart 4.1.2). The 5 5 peak amount outstanding for the current 4 4 facilities is significantly below the peak amount 3 3 outstanding for similar facilities that were 2 2 created during the 2008 financial crisis; many of the credit facilities, however, were not created 1 1 in the 2008 financial crisis. 0 0 2008 2010 2012 2014 2016 2018 2020 4.2 Council Activities Source: Federal Reserve, FRED Note: Wednesday level.
4.2.1 Risk Monitoring and Regulatory Coordination 4.1.2 Net Portfolio Holdings of 13(3) Facilities The Dodd-Frank Act charges the Council 4.1.2 Net Portfolio Holdings of 13(3) Facilities with the responsibility to identify risks to Billions of US$ As Of: 30-Sep-2020 Billions of US$ 300 300 U.S. financial stability, promote market PMCCF & SMCCF CPFF MLF discipline, and respond to emerging threats 250 PPP PDCF TALF 250 MMLF MSLF to the stability of the U.S. financial system. 200 200 The Council also has a duty to facilitate information sharing and coordination among 150 150 member agencies and other federal and state agencies regarding financial services policy 100 100 and other developments. The Council regularly 50 50 examines significant market developments and 0 0 structural issues within the financial system. Mar:2020 May:2020 Jul:2020 Sep:2020 This risk monitoring process is facilitated by the Council’s Systemic Risk Committee (SRC), Source: Federal Reserve, Haver Analytics Note: Wednesday level. whose participants are primarily member agency staff in supervisory, monitoring, examination, and policy roles. The SRC serves as a forum for member agency staff to identify and analyze potential risks, which may extend beyond the jurisdiction of any one agency. The Council’s Regulation and Resolution Committee (RRC) also supports the Council in its duties to identify potential gaps in regulation that could pose risks to U.S. financial stability.
The Council leveraged this infrastructure to respond to the COVID-19 pandemic. With the onset of the market stresses in March, the frequency of SRC meetings was increased from monthly to weekly or bi-weekly for the next
Council Activities and Regulatory Developments 143 six months to facilitate coordination, information- Act or are under review in Stage 1 or Stage 2 of the sharing, and analysis of key risk topics. Council’s designation process.
On March 30, 2020, the Council also convened a On December 4, 2019, the Council issued final principals-level task force on nonbank mortgage interpretive guidance replacing the Council’s liquidity to assess potential liquidity strains on prior interpretive guidance on nonbank financial nonbank originators and servicers. Following up company determinations, which was issued in on the task force discussion, the Council formed a 2012. The new interpretive guidance describes the staff-level working group that included non-Council approach the Council intends to take in prioritizing agencies to facilitate interagency coordination, its work to identify and address potential risks to additional market monitoring, and enhanced U.S. financial stability using an activities-based default planning for the possible failure and approach and enhances the analytical rigor and resolution of nonbank mortgage companies. transparency in the processes the Council intends to follow if it were to consider making a determination In July 2020, the Council established a working to subject a nonbank financial company to group composed of staff from Treasury, the Federal supervision by Federal Reserve. Reserve, and FHFA to assess potential risks related to the provision of secondary mortgage market On September 25, 2020, the Council approved a liquidity. The working group focused in particular statement summarizing its review of the secondary on the activities of Fannie Mae and Freddie Mac as mortgage market and presenting its key findings. the dominant private secondary market providers As noted above, the Council’s review focused in of liquidity through their purchase of mortgages particular on the activities of the Enterprises. for securitization and sale as guaranteed MBS. The In conducting the review, the Council applied working group assessed potential financial stability the framework for an activities-based approach risks in the secondary market, as well as whether described in the December 2019 final interpretive those risks are appropriately addressed by regulatory guidance. mitigants. The working group’s analysis informed the September 25, 2020 Council statement discussed The Council’s review noted the central role the below. Enterprises continue to play in the national housing finance markets, and found that any distress at the 4.2.2 Determinations Regarding Nonbank Financial Enterprises that affected their secondary mortgage Companies and Activities-Based Approach market activities, including their ability to perform One of the Council’s statutory authorities is to their guarantee and other obligations on their MBS subject a nonbank financial company to supervision and other liabilities, could pose a risk to financial by the Federal Reserve and enhanced prudential stability, if risks are not properly mitigated. The standards if the company’s material financial Council’s review also considered whether the distress—or nature, scope, size, scale, concentration, regulatory framework of the FHFA would adequately interconnectedness, or mix of its activities—could mitigate this potential risk posed by the Enterprises. pose a threat to U.S. financial stability. The Dodd- Frank Act sets forth the standard for the Council’s FHFA’s recent capital proposal was central to the determinations regarding nonbank financial Council’s analysis. The Council considered whether companies and requires the Council to take the proposed capital rule is appropriately sized and into account ten specific considerations and any structured, given the Enterprises’ risks and their key other risk-related factors that the Council deems role in the housing finance system, and also whether appropriate when evaluating those companies. the proposed capital rule promotes stability in the broader housing finance system (see Box F). As of the date of this report, no nonbank financial companies are subject to a final determination by the Council under Section 113 of the Dodd-Frank
144 2020 FSOC // Annual Report 4.2.3 Operations of the Council the capital rule. The final rule requires an advanced The Dodd-Frank Act requires the Council to approaches banking organization to use SA-CCR convene no less than quarterly. The Council to determine the exposure amount of derivative held [five] meetings in 2020, including at least contracts included in the banking organization’s one each quarter. The meetings bring Council total leverage exposure, the denominator of members together to discuss and analyze market the supplementary leverage ratio. In addition, developments, potential threats to financial stability, the final rule incorporates SA-CCR into the and financial regulatory issues. Although the cleared transactions framework and makes other Council’s work frequently involves confidential amendments, generally with respect to cleared supervisory and sensitive information, the Council transactions. The final rule requires advanced is committed to conducting its business as openly approaches banking organizations to use SA-CCR and transparently as practicable. Consistent with beginning January 1, 2022 and permits the option of the Council’s transparency policy, the Council using SA-CCR as early as March 31, 2020. opens its meetings to the public whenever possible. The Council held a public session at [three] of On January 27, 2020, the OCC, Federal Reserve, its meetings in 2020. Approximately every two and FDIC issued a final rule to implement section weeks, the Council’s Deputies Committee, which 402 of the Economic Growth, Regulatory Relief, is composed of senior representatives of Council and Consumer Protection Act (EGRRCPA). Section members, convenes to discuss the Council’s 402 directs these agencies to amend the regulatory agenda and to coordinate and oversee the work capital rule to exclude from the supplementary of the Council’s five other committees. The other leverage ratio certain funds of banking committees are the Data Committee; the Financial organizations deposited with central banks if the Market Utilities and Payment, Clearing, and banking organization is predominantly engaged in Settlement Activities Committee; the Nonbank custody, safekeeping, and asset servicing activities. Financial Companies Designations Committee; the RRC; and the SRC. The Council adopted its Actions Relating to CARES Act and Federal eleventh budget in 2020. Reserve Facilities Agencies issued a number of regulations pertaining 4.3 Safety and Soundness to the CARES Act and facilities that were established by the Federal Reserve pursuant to section 13(3) of 4.3.1 Enhanced Capital and Prudential Standards the Federal Reserve Act, in response to economic and Supervision disruptions caused by COVID-19 and volatility in On January 24, 2020, the OCC, Federal Reserve, U.S. financial markets. and FDIC issued a final rule implementing a new approach—the standardized approach for On March 23, 2020, the Federal Reserve, OCC, and counterparty credit risk (SA-CCR)—for calculating FDIC issued an interim final rule to allow banking the exposure amount of derivative contracts under organizations to neutralize the regulatory capital these agencies’ regulatory capital rule. Under effects of participating in the MMLF. The MMLF, the final rule, an advanced approaches banking established on March 18, 2020, authorized the organization may use SA-CCR or the internal Federal Reserve Bank of Boston to extend non- models methodology to calculate its advanced recourse loans to eligible financial institutions approaches total risk-weighted assets, and must to purchase certain types of assets from money use SA-CCR, instead of the current exposure market mutual funds in order to provide liquidity methodology, to calculate its standardized total to the money market sector to help stabilize the risk-weighted assets. A non-advanced approaches financial system. This treatment would extend to the banking organization may use the current community bank leverage ratio. exposure methodology or SA-CCR to calculate its standardized total risk-weighted assets. The final On April 13, 2020, the OCC, Federal Reserve, and rule also implements SA-CCR in other aspects of FDIC issued an interim final rule to allow banking
Council Activities and Regulatory Developments 145 organizations to neutralize the regulatory capital ratio requirement (transition interim final rule). effects of participating in the PPPLF. Under the The transition interim final rule provides that PPPLF, established on April 9, 2020, each of the the community bank leverage ratio will be 8 Federal Reserve Banks would extend non-recourse percent through December 31, 2020, in the event loans to eligible financial institutions to fund the statutory interim final rule terminates before loans guaranteed by the SBA under the PPP. This December 31, 2020, 8.5 percent through calendar treatment is similar to the treatment extended year 2021, and 9 percent thereafter. The transition previously by the agencies in connection with the interim final rule also maintains a two-quarter MMLF. In addition, as mandated by section 1102 grace period for a qualifying community banking of the CARES Act, loans originated under the organization whose leverage ratio falls no more than PPP will receive a zero percent risk weight under 1 percentage point below the applicable community the agencies’ regulatory capital rule, regardless of bank leverage ratio requirement. The agencies whether the lender participates in the PPPLF. issued the transition interim final rule to provide community banking organizations with sufficient Beginning on April 2, 2020, the SBA issued a time and clarity to meet the 9 percent leverage ratio number of interim final rules and guidance requirement under the community bank leverage documents to implement the PPP, a new forgivable ratio framework while they also focus on supporting loan program created by the CARES Act. The lending to creditworthy households and businesses CARES Act provides for forgiveness of up to the given the recent strains on the U.S. economy caused full principal amount of PPP loans, which are also by COVID-19. guaranteed by the SBA. The PPP provided economic relief to small businesses nationwide adversely On April 27, 2020, the NCUA issued an interim final impacted by the economic effects of COVID-19. rule to make a conforming amendment to its capital adequacy regulation following the enactment of On April 23, 2020, the OCC, Federal Reserve, and the CARES Act. The CARES Act requires that PPP FDIC issued an interim final rule making temporary loans receive a zero percent risk weighting under the changes to the community bank leverage ratio NCUA’s risk-based capital requirements. To reflect framework, pursuant to section 4012 of the CARES the statutory requirement, the interim final rule Act. Under the temporary change, a banking amends the NCUA’s capital adequacy regulation organization with a leverage ratio of 8 percent or to provide that covered PPP loans receive a zero greater (and that meets other qualifying criteria) percent risk weight. The rule provides that if the may elect to use the community bank leverage covered loan is pledged as collateral for a non- ratio framework. The statutory interim final rule recourse loan that is provided as part of the PPPLF, also established a two-quarter grace period for a the covered loan can be excluded from a credit qualifying community banking organization whose union’s calculation of total assets for the purposes leverage ratio falls below the 8-percent community of calculating its net worth ratio. The rule also bank leverage ratio requirement, so long as the makes a conforming amendment to the definition banking organization maintains a leverage ratio of of commercial loan in the NCUA’s member business 7 percent or greater. The temporary changes to the loans and commercial lending rule. In an additional community bank leverage ratio framework would interim final rule issued on April 29, the NCUA cease to be effective as of the earlier of December made further amendments conforming to the 31, 2020, or the termination date of the national CARES Act, and introduced changes intended to emergency concerning COVID-19. make it easier for credit unions to join the NCUA’s Central Liquidity Facility. Also on April 23, 2020, the OCC, Federal Reserve, and FDIC issued an interim final rule that provides On May 6, 2020, the OCC, Federal Reserve, and a graduated transition to a community bank FDIC issued an interim final rule to require banking leverage ratio requirement of 9 percent from the organizations to neutralize the effect under the LCR temporary 8-percent community bank leverage rule of participating in the MMLF and PPPLF. The
146 2020 FSOC // Annual Report rule was issued to facilitate the use of these Federal On March 20, 2020, the Federal Reserve, OCC, Reserve facilities, and to ensure that the effects of and FDIC issued an interim final rule revising their use are consistent and predictable under the the definition of eligible retained income for all LCR rule. depository institutions, BHCs, and savings and loan holding companies subject to the agencies’ On June 26, 2020, the FDIC issued a final rule capital rule. The revised definition would make any that mitigates the deposit insurance assessment automatic limitations on capital distributions that effects of participating in the PPPLF, MMLF, and could apply under the agencies’ capital rules more PPP. Specifically, the rule removes the effect of gradual. The definition was revised again by an participation in the PPP and borrowings under the interim final rule issued the following week to make PPPLF on various risk measures used to calculate any automatic limitations on capital distributions the assessment rate of an insured depository that could apply under the total loss-absorbing institution; removes the effect of participation in the capacity (TLAC) rule more gradually. PPP and MMLF program on certain adjustments to an insured depository institution’s assessment On March 22, 2020, the Federal Reserve, CSBS, rate; provides an offset to an insured depository CFPB, FDIC, NCUA, and OCC issued an interagency institution’s assessment for the increase to its statement encouraging financial institutions to offer assessment base attributable to participation in prudent loan modification programs to mitigate the PPP and MMLF; and removes the effect of adverse impacts of COVID-19 on borrowers, improve participation in the PPP and MMLF when classifying loan performance, and reduce credit risk. Agencies insured depository institutions as small, large, or noted that banks may presume that borrowers are highly complex for assessment purposes. not experiencing financial difficulty when short- term loan modifications (for example, six months) Additional Guidance and Regulatory Actions in are made on a good faith basis in response to Response to COVID-19 COVID-19. If those borrowers were current prior to Finally, agencies issued numerous additional any relief provided, the loan modifications are not guidance statements and regulatory changes in considered troubled debt restructurings (TDRs). response to the economic and financial impact Such modifications include payment deferrals, fee of COVID-19, including temporary relaxations of waivers, extensions of repayment terms, or other prudential standards and supervisory requirements insignificant delays in payment. Agencies said and modifications of compliance deadlines. examiners would not automatically adversely risk rate credits that are affected by loan modifications, In the second week of March 2020, the Federal and regardless of whether or not modifications Reserve encouraged financial institutions to are considered TDRs, or are adversely classified, review its SR letter 13-6 / CA letter 13-3, published examiners would not criticize prudent loan in March 2013, entitled “Supervisory Practices modification efforts. In the same week, the Federal Regarding Banking Organizations and their Reserve outlined adjustments to its supervisory Borrowers and Other Customers Affected by a approach that would prioritize outreach and Major Disaster or Emergency.” On March 13, the monitoring while temporarily reducing examination FDIC issued Financial Institution Letter 17-2020, activities, particularly for smaller banks. Large encouraging financial institutions supervised by banks were instructed to submit their capital analysis the FDIC to take prudent steps to assist customers plans, while additional time would be granted to and communities affected by COVID-19. Agencies resolve non-critical, existing supervisory findings. encouraged banking organizations to use the Federal Reserve discount window and the capital On March 25, 2020, the OCC issued an interim final and liquidity buffers designed to enable banking rule revising the agency’s short-term investment organizations to continue to serve households and fund (STIF) rule for national banks acting in a businesses and support the economy in adverse fiduciary capacity. The rule allowed the OCC to situations. authorize banks to temporarily extend the maturity
Council Activities and Regulatory Developments 147 limits of STIFs in light of a period of significant through March 31, 2021. The rule was adopted to stress negatively affecting the ability of banks to allow BHCs, savings and loan holding companies, operate in compliance with the maturity limits and intermediate holding companies subject to the identified in the rule. The OCC simultaneously supplementary leverage ratio increased flexibility to announced an order temporarily extending the continue to act as financial intermediaries. The tier maturity limits for STIFs affected by the market 1 leverage ratio is not affected by this rulemaking. effects of COVID-19 upon certain conditions, including a determination by the bank that it would On April 17, 2020, the FDIC, OCC, and Federal be acting in the best interests of the STIF under Reserve issued an interim final rule that allows applicable law. The order extended the weighted institutions supervised by the agencies to defer average maturity and weighted average life of STIF obtaining an appraisal or evaluation for up to 120 investment portfolios to allow national banks to days after the closing of certain residential and operate affected STIFs on a limited-time basis with commercial real estate loans. increased maturity limits until July 20, 2020. On April 21, 2020, the NCUA issued a temporary On March 27, 2020, the Federal Reserve, OCC, and final rule temporarily raising the maximum FDIC announced that institutions were permitted aggregate amount of loan participations that a to adopt early the SA-CCR rule for the reporting federally insured credit union (FICU) may purchase period ending March 31, on a best-efforts basis, from a single originating lender to the greater of to help improve market liquidity. SA-CCR was $5,000,000 or 200 percent of the FICU’s net worth. previously set to go into effect on April 1, 2020. On The NCUA also temporarily suspended limitations April 7, the Federal Reserve, FDIC, NCUA, OCC, on the eligible obligations that a federal credit and CFPB issued the “Interagency Statement on union (FCU) may purchase and hold. In addition, Loan Modifications and Reporting for Financial given physical distancing policies implemented in Institutions Working with Customers Affected by response to the crisis, the agency tolled the required the Coronavirus (Revised)” to clarify the interaction timeframes for the occupancy or disposition of between the March 22, 2020, interagency statement properties not being used for FCU business or and section 4013 of the CARES Act. Section 4013 that have been abandoned. These temporary created a forbearance program for federally backed modifications were set in place until December 31, mortgage loans, protected borrowers from negative 2020, unless extended. credit reporting due to loan accommodations related to the National Emergency, and provided On May 28, 2020, the Federal Reserve issued a financial institutions the option to temporarily final rule that amends compliance dates related to suspend certain requirements under the U.S. Single-Counterparty Credit Limits for BHCs and generally accepted accounting principles (GAAP) Foreign Banking Organizations (final SCCL rule), related to TDR for a limited period of time to regarding the SCCL applicable to a foreign banking account for the effects of COVID-19. organization’s combined U.S. operations only. The rule changed initial compliance dates of January 1, On April 14, 2020, the Federal Reserve issued an 2020, for a foreign banking organization that has interim final rule that revises, on a temporary basis the characteristics of a global systemically important for BHCs, savings and loan holding companies, banking organization (G-SIB), and July 1, 2020, for and U.S. intermediate holding companies of any other foreign banking organization subject to foreign banking organizations, the calculation the final SCCL rule, to July 1, 2021 and January 1, of total leverage exposure, the denominator of 2022, respectively. the supplementary leverage ratio in the Federal Reserve’s capital rule, to exclude the on-balance Also on May 28, 2020, the NCUA issued an sheet amounts of U.S. Treasury securities and interim final rule that temporarily modifies its deposits at Federal Reserve Banks. This exclusion prompt corrective action (PCA) regulations to has immediate effect and will remain in effect help ensure that FICUs would remain operational
148 2020 FSOC // Annual Report and liquid during the COVID-19 crisis. The first On June 5, 2020, the OCC issued a final rule temporary change enables the agency to issue to strengthen and modernize the Community an order applicable to all FICUs to waive the Reinvestment Act (CRA) by clarifying and earnings retention requirement for any FICU that expanding the activities that qualify for CRA credit; is classified as adequately capitalized. The second updating where activities count for CRA credit; modifies its regulations with respect to the specific creating a more consistent and objective method documentation required for net worth restoration for evaluating CRA performance; and providing plans for FICUs that become undercapitalized. for more timely and transparent CRA-related These temporary modifications were set in place data collection, recordkeeping, and reporting. In until December 31, 2020. addition, the OCC, Federal Reserve, and FDIC released a statement in March noting that the On June 1, 2020, the OCC, Federal Reserve, and agencies would favorably consider retail banking FDIC issued an interim final rule temporarily services and retail lending activities that meet the revising the supplementary leverage ratio calculation needs of low- and moderate-income individuals, for depository institutions. Under the interim small businesses, and small farms affected by final rule, any depository institution subsidiary of COVID-19 and that are consistent with safe and a U.S. global systemically important BHC or any sound banking practices and applicable laws, depository institution subject to Category II or including consumer protection laws. Such activities Category III capital standards may elect to exclude could include offering short-term, unsecured credit temporarily U.S. Treasury securities and deposits products for creditworthy borrowers. at Federal Reserve Banks from the supplementary leverage ratio denominator. Additionally, under On June 15, 2020, the Federal Reserve announced this interim final rule, any depository institution that it would resume examination activities for making this election must request approval from all banks, after having reduced examination its primary federal banking regulator prior to activity in March. Also in June, the Federal making certain capital distributions so long as the Reserve, FDIC, NCUA, OCC, and state regulators exclusion is in effect. The interim final rule, like published examiner guidance to promote the related rule issued on April 14, was adopted consistency and flexibility in the supervision and to allow depository institutions that elect to opt examination of financial institutions affected into this treatment additional flexibility to act as by the COVID-19 pandemic. Examiners will financial intermediaries during this period of continue to assess institutions in accordance with financial disruption. The rule will remain in effect existing agency policies and procedures and may through March 31, 2021 and does not affect the tier provide supervisory feedback or downgrade an 1 leverage ratio. institution’s composite or component ratings, when conditions have deteriorated. In conducting their Also on June 1, 2020, the OCC, Federal Reserve, supervisory assessment, examiners will consider FDIC, and NCUA issued final guidance for whether institution management has managed risk credit risk review. This guidance is relevant to appropriately, including taking appropriate actions all institutions supervised by the agencies and in response to stresses caused by COVID-19 impacts. replaces Attachment 1 of the 2006 Interagency The agencies have issued numerous statements Policy Statement on the Allowance for Loan and related to supervisory policy since the emergence of Lease Losses. The final guidance discusses sound the pandemic. management of credit risk, a system of independent, ongoing credit review, and appropriate On June 24, 2020, the OCC issued an interim final communication regarding the performance of the rule to lower assessments for most banks under its institution’s loan portfolio to its management and jurisdiction. Under the new rule, assessments due board of directors. on September 30, 2020 for national banks, federal savings associations, and federal branches and agencies of foreign banks will be calculated using
Council Activities and Regulatory Developments 149 the December 31, 2019 “Consolidated Reports of 15 of each year. Covered institutions are required to Condition and Income” (Call Report) for each use the scenarios to conduct annual stress tests. The institution, rather than the June 30, 2020 Call results of the company-run stress tests will assist the Report. In the event a bank’s assets as reported on agency in assessing the company’s risk profile and the June 30, 2020 Call Report are lower than on capital adequacy. the December 31, 2019 Call Report, the OCC would calculate the assessment due on September 30, On March 18, 2020, the Federal Reserve issued a 2020 for the institution using the June 30, 2020 Call final rule intended to simplify its capital framework Report. while preserving strong capital requirements for large firms. The final rule integrates the On August 3, 2020, the Federal Financial regulatory capital rule (capital rule) with CCAR, Institutions Examination Council on behalf of its as implemented through the capital plan rule. The members issued a statement setting forth prudent final rule makes amendments to the capital rule, risk management and consumer protection capital plan rule, stress test rules, and Stress Testing principles for financial institutions to consider while Policy Statement. Under the final rule, the Federal working with borrowers as initial coronavirus-related Reserve will use the results of its supervisory stress loan accommodation periods come to an end and test to establish the size of a firm’s stress capital they consider additional accommodations. buffer requirement, which replaces the static 2.5 percent of risk-weighted assets component of a firm’s On August 13, 2020, the OCC published an interim capital conservation buffer requirement. Through final rule that revised OCC regulations applicable the integration of the capital rule and CCAR, to OCC-regulated banks administering collective the final rule removes redundant elements of the investment funds (CIFs) invested primarily in real current capital and stress testing frameworks that estate or other assets that are not readily marketable. currently operate in parallel rather than together, The rule codified the time period generally including the CCAR quantitative objection and the available to a bank for withdrawing accounts from assumption that a firm makes all capital actions these CIFs and created an exception allowing a bank under stress. The final rule applies to BHCs and U.S. to extend the time period for withdrawals with OCC intermediate holding companies of foreign banking approval. The exception established by this rule was organizations that have $100 billion or more in total intended to enable a bank to preserve the value of consolidated assets. a CIF’s assets for the benefit of fund participants during unanticipated and severe market conditions, On March 24, 2020, the FHFA issued a final rule such as those resulting from COVID-19. amending its stress testing rule, pursuant to section 401 of EGRRCPA. These amendments adopt the 4.3.2 Dodd-Frank Act Stress Tests and proposed amendments without change to modify Comprehensive Capital Analysis and Review the minimum threshold for the regulated entities Section 165(i)(2) of the Dodd-Frank Act requires to conduct stress tests from $10 billion to $250 certain financial companies to conduct annual stress billion; remove the requirements for Federal Home tests. Loan Banks subject to stress testing; and remove the adverse scenario from the list of required scenarios. On February 6, 2020, the Federal Reserve and OCC, These amendments align FHFA’s rule with rules followed by the FDIC on February 14, released adopted by other financial institution regulators economic and financial market scenarios for use in that implement the Dodd-Frank Act stress testing upcoming stress tests for covered institutions. The requirements, as amended by EGRRCPA. supervisory scenarios include baseline and severely adverse scenarios, as described in the agencies’ final 4.3.3 Resolution Planning and Orderly Liquidation rule that implements stress test requirements of the Under the framework of the Dodd-Frank Act, Dodd-Frank Act. Rules state that the agencies will resolution under the U.S. Bankruptcy Code is the provide scenarios to covered institutions by February statutory first option in the event of the failure of
150 2020 FSOC // Annual Report a financial company. Section 165(d) of the Dodd- firms in developing their resolution plans. It would Frank Act requires nonbank financial companies impact FBOs that are triennial filers and whose designated by the Council for supervision by the intermediate holding companies have a score of Federal Reserve and certain BHCs—including 250 or more under the second methodology of certain FBOs with U.S. operations—to periodically the G-SIB surcharge framework. The proposed submit plans to the Federal Reserve, the FDIC, and guidance, which is largely based on prior guidance, the Council for their rapid and orderly resolution describes the agencies’ expectations regarding under the U.S. Bankruptcy Code in the event a number of key vulnerabilities in plans for a of material financial distress or failure. These rapid and orderly resolution under the U.S. submissions are also referred to as living wills. The Bankruptcy Code (i.e., capital, liquidity, governance Federal Reserve and FDIC review each plan and mechanisms, operational, legal entity rationalization may jointly determine that a plan is not credible and separability, and derivatives and trading or would not facilitate an orderly resolution of the activities). The proposed guidance also updates company under the U.S. Bankruptcy Code. Since certain aspects of prior guidance based, in part, on the resolution planning requirements took effect the agencies’ review of certain FBOs’ most recent in 2012, U.S. G-SIBs and certain other firms have resolution plan submissions and changes to the improved their resolution strategies and governance, resolution planning rule. refined their estimates of liquidity and capital needs in resolution, and simplified their legal structures. On May 6, 2020, in light of the challenges arising These changes have made these firms more resilient from the coronavirus response, the FDIC and the and resolvable. Federal Reserve extended the 2020 resolution plan submission deadline by 90 days to September 29, On December 17, 2019, the Federal Reserve and 2020 for four foreign banks, and the 2021 targeted FDIC jointly announced that their review of the resolution plan submission deadline by 90 days 2019 resolution plans of the eight largest and most to September 29, 2021 for the large foreign and complex domestic banking organizations did not domestic banks in Category II and Category III of find any “deficiencies,” which are weaknesses that the agencies’ large bank regulatory framework. could result in additional prudential requirements if not corrected. However, plans from six of the On July 1, 2020, the FDIC and the Federal Reserve eight banking organizations had “shortcomings,” provided information to the eight largest and most which are weaknesses that raise questions about the complex domestic banking organizations that will feasibility of a firm’s plan but are not as severe as a guide their next resolution plans, which are due deficiency. The shortcomings related to the ability of by July 1, 2021. The 2021 plans will be required the firms to reliably produce, in stressed conditions, to include core elements of a firm’s resolution data needed to execute their resolution strategy. plan—such as capital, liquidity, and recapitalization strategies—as well as how each firm has integrated Action plans to address the shortcomings were due changes to, and lessons learned from, its response to the agencies by April 30, 2020. The action plans to COVID-19 into its resolution planning process. demonstrated progress towards addressing the The July 2021 submission will be the first targeted shortcomings. The agencies will review whether the resolution plan, a type of plan introduced in shortcomings have been addressed adequately, in the revisions to the agencies’ resolution plan connection with their review of the 2021 targeted rule finalized last year. resolution plans for these firms. Additionally, on July 1, 2020, the FDIC and the On March 18, 2020, the FDIC and Federal Reserve Federal Reserve announced that they recently invited comments on proposed guidance for the completed a review of “critical operations,” which 2021 and subsequent resolution plan submissions are operations at certain firms whose failure or by certain foreign banking organizations (FBOs). discontinuance would threaten U.S. financial The proposed guidance is meant to assist these stability, and informed the firms of their findings.
Council Activities and Regulatory Developments 151 The agencies also announced their plan to complete addressing the extraterritorial treatment of certain another such review by July 2022, which will include foreign funds; and permitting banking entities to a further, broader evaluation of the framework used offer financial services and engage in other activities to identify critical operations. that do not raise concerns that the Volcker Rule was intended to address. Furthermore, in 2020, the Federal Reserve and FDIC hosted Crisis Management Group (CMG) 4.3.5 Insurance meetings for U.S. G-SIBs to discuss home and host NAIC / State Developments resolvability assessments for the firms to facilitate In response to the COVID-19 pandemic, state cross-border resolution planning. insurance regulators and the NAIC provided guidance to insurers in several areas and sought On August 31, 2020, the FDIC and SEC issued a information to better understand the pandemic’s final rule required by the Dodd-Frank Act, which scope and potential coverage issues. States removed clarifies and implements provisions relating to the consumer cost-sharing for COVID-19 testing in most orderly liquidation of certain brokers or dealers health insurance policies and continue to work with (covered broker-dealers) in the event the FDIC is federal officials to implement additional measures appointed receiver under Title II of the Dodd-Frank enacted by Congress. States also issued bulletins that Act. The FDIC and SEC developed the final rule in provided guidance to health insurers on consultation with the Securities Investor Protection prescription drug refills, prior authorization, grace Corporation (SIPC). periods, and coverage of telemedicine. Regulators also took steps to ease administrative burdens on Among other things, the final rule clarifies that, carriers and agents and expand the pool of health upon the appointment of the FDIC as receiver, the providers in some states by relaxing licensing or FDIC would appoint SIPC to act as trustee for the credentialing requirements. broker-dealer. SIPC, as trustee, would determine and satisfy customer claims in the same manner as it Some states have required or encouraged insurers would in a proceeding under the Securities Investor to defer premium payments for consumers Protection Act of 1970. The treatment of the covered experiencing financial hardship due to COVID-19. broker-dealer’s qualified financial contracts would Regulators in several states also issued directives be governed in accordance with Title II. In addition, on policy cancellations and non-renewals in several the final rule describes the claims process applicable lines of insurance including health insurance, to customers and other creditors of a covered life insurance, auto insurance, and homeowners’ broker-dealer and clarifies the FDIC’s powers as insurance. Several states have mandated or receiver with respect to the transfer of assets of a encouraged auto insurance companies to covered broker-dealer to a bridge broker-dealer. institute premium rebates to drivers, who have significantly reduced miles driven during the 4.3.4 Volcker Rule pandemic, and several major auto insurers also On July 31, 2020, the OCC, Federal Reserve, FDIC, provided rebates voluntarily. SEC, and CFTC issued a final rule that amends the regulations implementing section 13 of the The NAIC and state insurance regulators took BHC Act. Section 13 (commonly known as the several actions to identify the potential risks Volcker Rule) contains certain restrictions on the that COVID-19 might present to the insurance ability of a banking entity or nonbank financial sector. Earlier this year, state insurance regulators company supervised by the Board to engage in through the NAIC issued an industry data call proprietary trading and have certain interests in, or to assess the potential impacts of COVID-19 on relationships with, a hedge fund or private equity insurance company solvency as well as a data call fund. Like the proposal published in February, for information specifically relating to business the final rule modifies three areas of the rule by interruption insurance. An initial set of this data was streamlining the covered funds portion of the rule; shared with FIO to assist it in exercising its statutory
152 2020 FSOC // Annual Report authorities, including monitoring all aspects of the similar agreement, known as the U.S.-UK Covered insurance industry and advising the Secretary of the Agreement, which is expected to enter into force Treasury on major domestic insurance policy issues. shortly. Both agreements were negotiated by Treasury in coordination with the Office of the The NAIC also issued accounting and reporting United States Trade Representative, pursuant to the guidance to temporarily help mitigate the balance Federal Insurance Office Act of 2010 (FIO Act). sheet impacts of COVID-19, including guidance relating to troubled debt restructuring, mortgage In June 2019, in response to the covered agreements loan impairments, and nonpayment of premiums. with the EU and the UK, the NAIC adopted Following up on stress tests that the NAIC changes to the Credit for Reinsurance Model Law conducted in late 2019 relating to the insurance and Credit for Reinsurance Model Regulation. industry’s $158 billion in CLO holdings, the NAIC The changes are intended to provide states with ran additional stress tests in spring 2020 that found a model law and regulation that, upon adoption, senior tranches might be protected from widespread aligns state law with the U.S. obligations under the losses in a deep recession. agreements. In August 2020, the NAIC designated these revisions under its accreditation program, to In addition to work relating to the COVID-19 take effect September 1, 2022. Pursuant to the terms response, state insurance regulators continued of the covered agreements, this is the date by which work on their Group Capital Calculation (GCC), the United States must complete any necessary which began in 2015. The GCC is designed to preemption determination in accordance with be an analytical tool that will give regulators the FIO Act. Some states have already completed information relating to the capital across certain the adoption of necessary amendments. Not later insurance groups. Adoption of a model, including than March of 2021, as required under the covered proposed legislative language for states that would agreements, FIO will begin reviewing the progress protect GCC confidentiality, is expected in late of each of the states and evaluating a potential 2020. Adoption by U.S. insurance supervisory preemption determination. authorities of a GCC is also necessary for purposes of implementation of the covered agreements Cybersecurity described below. In July 2020, the New York Department of Financial Services (NYDFS) filed its first-ever enforcement The NAIC has continued to make progress on action under its 2017 cybersecurity regulation its Macroprudential Initiative, including the against a title insurer for alleged exposure of development of a liquidity stress test for large life hundreds of millions of documents, many of which insurers. Work on this initiative was placed on were said to contain sensitive personal information. hold due to COVID-19 and, in its place, COVID-19 liquidity data calls were conducted on the largest life As of June 30, 2020, eleven states—Alabama, insurers to gauge the liquidity and capital impact of Connecticut, Delaware, Indiana, Louisiana, the pandemic on such insurers. Michigan, Mississippi, New Hampshire, Ohio, South Carolina, and Virginia—had adopted the NAIC’s Covered Agreements Insurance Data Security Model Law or similar law. The Bilateral Agreement between the United States of America and the European Union on Prudential Terrorism Risk Insurance Program Measures Regarding Insurance and Reinsurance, The Federal Insurance Office assists the Secretary generally known in the United States as the U.S.- of the Treasury in administering the Terrorism EU Covered Agreement, was signed by the parties Risk Insurance Program (TRIP) created under the in September 2017. It entered into force on April 4, Terrorism Risk Insurance Act of 2002, as amended 2018. In anticipation of the withdrawal of the United (TRIA). Under the Terrorism Risk Insurance Kingdom (UK) from the EU, in 2018 the United Program Reauthorization Act of 2019, TRIP has States and the UK entered into a substantively been reauthorized for an additional seven-year
Council Activities and Regulatory Developments 153 period, ending December 31, 2027. Since 2016, 4.4 Financial Infrastructure, Markets, and Treasury has been required under TRIA to collect Oversight terrorism risk insurance information from insurers. 4.4.1 Derivatives, Swap Data Repositories, In June 2020, Treasury published a Report on Regulated Trading Platforms, and Central the Effectiveness of the Terrorism Risk Insurance Counterparties Program. In the report, Treasury concluded that On September 19, 2019, the SEC issued a final TRIP has remained effective in making terrorism rule, in accordance with the Dodd-Frank Act and risk insurance available and affordable in the pursuant to the Securities Exchange Act of 1934 insurance marketplace and that the market for (Exchange Act) which adopts recordkeeping, terrorism risk insurance has been relatively stable, reporting, and notification requirements applicable with few observable changes over time in the to security-based swap dealers (SBSDs) and relevant benchmarks. major security-based swap participants (MSBSPs), securities count requirements applicable to certain IAIS Update SBSDs, and additional recordkeeping requirements In November 2019, the International Association applicable to broker-dealers to account for their of Insurance Supervisors (IAIS) advanced version security-based swap and swap activities. The 2.0 of the International Capital Standard (ICS) agency also made substituted compliance available into a five-year monitoring period from 2020 with respect to recordkeeping, reporting, and through 2024. The IAIS agreement consisted of notification requirements under Section 15F of the three parts: (1) the design of the reference ICS Exchange Act and the rules thereunder. being developed by the IAIS; (2) the parameters around the operationalization of the ICS In January 2020, the CFTC finalized amendments monitoring period; and (3) the IAIS’s approach to to Part 39 of its regulations as part of its ongoing the comparability assessment of the Aggregation review of regulations applicable to CCPs. The Method. The November 2019 IAIS meetings also amendments address certain risk management resulted in the adoption of the holistic framework and reporting obligations, clarify the meaning of for the assessment and mitigation of systemic risk certain provisions, simplify processes for registration in the insurance sector, leveraging an activities- and reporting, and codify existing staff relief and based approach to assessing potential systemic risks guidance. arising from products and activities. In October 2020, FIO published a notice in the Federal Register On February 4, 2020, the SEC issued a final rule that seeking public comment on a planned FIO study to requires the application of specific risk mitigation assess the potential effects of the ICS on the U.S. techniques to portfolios of uncleared security- insurance market, including the implications for based swaps. In particular, the final rule establishes product cost and availability for U.S. consumers, the requirements for each registered SBSD and each global competitiveness of U.S. insurers, and insurer registered MSBSP regarding, among other things, investment behavior in the capital markets. reconciling outstanding security-based swaps with applicable counterparties on a periodic basis, In response to the onset of the COVID-19 global engaging in certain forms of portfolio compression pandemic, the IAIS refocused its activities and exercises, as appropriate, and executing written projects on the impact of COVID-19. In addition, the security-based swap trading relationship IAIS issued a data call that focused on the effects documentation with each of its counterparties prior of the COVID-19 global pandemic on the global to, or contemporaneously with, executing a security- insurance sector. The IAIS has also been monitoring based swap transaction. The SEC also issued an supervisory responses to the pandemic and assessing interpretation addressing the application of the the implications on the global insurance sector. portfolio reconciliation, portfolio compression, and trading relationship documentation requirements to cross-border security-based swap activities,
154 2020 FSOC // Annual Report and amended its regulations to address the The CFTC has adopted several modifications to its potential availability of substituted compliance in rules imposing margin requirements on uncleared connection with those requirements. Lastly, the swap transactions during the past year. On April final rule includes corresponding amendments 9, 2020, the CFTC issued a final rule revising to the recordkeeping, reporting, and notification its margin rules by establishing an additional requirements applicable to SBSDs and MSBSPs. compliance phase-in period (phase 6) and setting a September 1, 2021, compliance date for phase The same day, the SEC issued separate rule 6 entities. This amendment is intended to help amendments pursuant to a final rule and provided ensure continued access to the swaps markets for guidance to address the cross-border application of certain entities with relatively smaller levels of swaps certain security-based swap requirements under the trading activities that may have difficulty meeting Exchange Act that were added by Title VII of the all of the operational conditions to exchange initial Dodd-Frank Act. The SEC also issued a statement margin and is consistent with revisions adopted regarding compliance with rules for security-based by the Basel Committee on Banking Supervision swap data repositories and Regulation SBSR, a and the International Organization of Securities regulation that addresses regulatory reporting and Commission (BCBS/IOSCO) to their joint public dissemination of security-based swaps. The international framework for margin requirements compliance date for the registration and substantive for non-centrally cleared derivatives. On May 11, regulation of SBSDs and MSBSPs is October 6, 2021. 2020, the CFTC issued a final rule amending its In addition, these entities are required to begin margin rules to exclude the European Stability counting their security-based swap transactions Mechanism from the scope of the rules. towards the de minimis thresholds for registration on August 6, 2021. On July 1, 2020, the Federal Reserve, FDIC, FCA, FHFA, and OCC issued a final rule that amends On March 18, 2020, the CFTC issued a final the agencies’ regulations requiring swap dealers rule that amends its regulations governing the offer (SDs), SBSDs, major swap participants (MSPs), and and sale of foreign futures and options to customers MSBSPs under the agencies’ respective jurisdictions located in the U.S. The amendment codifies to exchange margin with their counterparties for the process by which the agency may terminate swaps that are not centrally cleared (Swap Margin exemptive relief issued pursuant to its regulations. Rule). The Swap Margin Rule as adopted in 2015 takes effect under a phased compliance schedule On March 24, 2020, the SEC proposed to amend 17 spanning from 2016 through 2020, and the entities CFR 242, Rules 600 and 603 and to adopt new Rule covered by the rule continue to hold swaps in their 614 of Regulation National Market System (NMS) portfolios that were entered into before the effective under the Exchange Act to update the national dates of the rule. Such swaps are grandfathered market system for the collection, consolidation, from the Swap Margin Rule’s requirements until and dissemination of information with respect to they expire according to their terms. The final rule quotations for and transactions in NMS stocks (NMS permits swaps entered into prior to an applicable information). This would expand the content of compliance date (legacy swaps) to retain their legacy NMS information that is required to be collected, status in the event that they are amended to replace consolidated, and disseminated as part of the NMS an interbank offered rate or other discontinued under Regulation NMS and proposes to amend rate, modifies initial margin requirements for the method by which such NMS information non-cleared swaps between affiliates, introduces is collected, calculated, and disseminated by an additional compliance date for initial margin introducing a decentralized consolidation model requirements, clarifies the point in time at which where competing consolidators replace the exclusive trading documentation must be in place, permits securities information processors. legacy swaps to retain their legacy status in the event that they are amended due to technical amendments, notional reductions, or portfolio
Council Activities and Regulatory Developments 155 compression exercises, and makes technical changes On July 24, 2020, the CFTC issued a final rule to to relocate the provision addressing amendments prohibit post-trade name give-up for swaps executed, to legacy swaps that are made to comply with the pre-arranged, or pre-negotiated anonymously on Qualified Financial Contract Rules. In addition, or pursuant to the rules of a swap execution facility the final rule addresses comments received in and intended to be cleared. The final rule provides response to the agencies’ publication of the interim an exception for package transactions that include final rule that would preserve the status of legacy a component transaction that is not a swap intended swaps meeting certain criteria in the case of a to be cleared, including but not limited to U.S. Brexit without a negotiated settlement agreement. Treasury swap spreads. The same day, the agencies issued an interim final rule, with request for comment, extending the On September 14, 2020, the CFTC issued a final rule implementation deadlines of phase 5 and phase 6 that addresses the cross-border application of the by one year, to September 1, 2021, and September 1, SD registration threshold and certain requirements 2022, respectively. applicable to SDs and MSPs, establishes a formal process for requesting comparability determinations On July 10, 2020, the CFTC issued an interim final for the requirements from the CFTC, and rule further amending its initial margin compliance defines key terms for the purpose of applying the schedule to address operational challenges as a Commodity Exchange Act’s swaps provisions to result of the coronavirus pandemic. The interim cross-border transactions. This approach considers final rule deferred the compliance date for phase 5 international comity principles and the CFTC’s entities to September 1, 2021. The CFTC in October interest in focusing its authority on potential 2020 also extended the phase 6 compliance date significant risks to the U.S. financial system. This to September 1, 2022. The CFTC’s actions were final rule supersedes the CFTC’s 2013 cross-border consistent with revisions made by the BCBS/IOSCO guidance with respect to the CFTC requirements to the implementation schedule of the international covered by the final rule. framework for margin requirements for non- centrally cleared derivatives. On September 15, 2020, the CFTC issued a final rule imposing capital and financial reporting On July 22, 2020, the CFTC issued a final rule requirements on SDs and MSPs that are not subject amending regulation 50.52, which exempts certain to a banking regulator. The adoption of the capital affiliated entities within a corporate group from the requirements completes the CFTC’s obligations swap clearing requirement under Section 2(h) of under Title VII of the Dodd-Frank Act to adopt rules the Commodity Exchange Act. These amendments imposing both capital and margin requirements concern the anti-evasionary condition to the on SDs and MSPs. The capital rules recognize inter-affiliate exemption from the swap clearing the diversity of organizations registered with the requirement. Under this condition, affiliates CFTC as SDs, which includes global financial electing the exemption must ensure that swaps institutions, small SDs that engage primarily in subject to the clearing requirement entered into swaps with commercial end-users, and agricultural with unaffiliated counterparties either be cleared or energy firms, by permitting the SDs to elect or be eligible for an exception to or exemption one of three capital approaches: (1) a bank-based from the clearing requirement. The amendments capital approach that is consistent with the capital make permanent certain temporary alternative rules of the prudential regulators; (2) a capital compliance frameworks intended to make this anti- approach that is consistent with the CFTC’s existing evasionary condition workable for international FCM and the SEC’s existing securities broker- corporate groups in the absence of foreign clearing dealer capital requirements; and, (3) for SDs regimes determined to be comparable to CFTC predominantly engaged in nonfinancial activities, a requirements. capital requirement based on the SD’s tangible net worth. The CFTC’s final capital rules also require MSPs to maintain positive tangible net worth. The
156 2020 FSOC // Annual Report financial reporting requirements require SDs and 4.4.2 Securities and Asset Management MSPs to file with the CFTC, among other reports, On March 10, 2020, the SEC issued a final rule periodic unaudited financial statements and annual amending the definition of the term “venture capital audited financial statements. The CFTC capital and fund” and the private fund adviser exemption financial reporting rules have a compliance date of under the Investment Advisers Act of 1940 (Advisers October 6, 2021. Act) to reflect exemptions from registration for investment advisers who advise rural business On September 22, 2020, the CFTC issued an NPRM investment companies (RBICs). These exemptions proposing amendments to the CFTC margin rules were enacted as part of the RBIC Advisers Relief to permit the application of a minimum transfer Act, which amended Advisers Act sections 203(l) amount of up to $50,000 for each separately and 203(m), among other provisions. Specifically, managed account of a counterparty to a CFTC- the RBIC Advisers Relief Act amended Advisers regulated SD or MSP, and the application of Act section 203(l), which exempts from investment separate minimum transfer amounts for initial adviser registration any adviser who solely advises and variation margin. In addition, on September venture capital funds, by stating that RBICs are 23, 2020, the CFTC issued an NPRM proposing venture capital funds for purposes of the exemption. amendments to the definition of the term “material Accordingly, the new rule amended the definition swaps exposure” by revising the method for of the term “venture capital fund” to include RBICs. calculating the average aggregate notional amount The RBIC Advisers Relief Act also amended Advisers of swaps and other financial derivatives products Act section 203(m), which exempts from investment (AANA). The proposed amendment would change adviser registration any adviser who solely advises the period for calculating AANA from June, July, private funds and has AUM in the United States of and August of the prior year to March, April, and less than $150 million, by excluding RBIC assets May of the current year, and the data points for from counting towards the $150 million threshold. calculating AANA, by utilizing month-end dates Accordingly, the final rule amends the definition rather than daily figures during the three-month of AUM in the private fund adviser exemption to calculation period. The proposed amendment would exclude the assets of RBICs. also establish September 1 of each year as the date for determining material swaps exposure. These On March 26, 2020, the SEC issued a final rule that proposed changes would align the CFTC’s approach amends the accelerated filer and large accelerated with the BCBS/IOSCO’s margin framework. The filer definitions to tailor the types of issuers that are proposal would also permit an SD or MSP subject to included in the categories of accelerated and large the CFTC margin rule to use the risk-based model accelerated filers and promote capital formation, calculation of initial margin of a counterparty that preserve capital, and reduce unnecessary burdens is a CFTC-registered SD or MSP rather than its own for certain smaller issuers while maintaining initial margin calculation. investor protections. The amendments exclude from the accelerated and large accelerated filer CMGs continued to coordinate resolution planning definitions an issuer that is eligible to be a smaller for two U.S. CCPs that are considered systemically reporting company and that had annual revenues of important in more than one jurisdiction, consistent less than $100 million in the most recent fiscal year with international standards. The CMGs discussed for which audited financial statements are available. how the two U.S. CCPs navigated the operational The amendments also include a specific provision and financial challenges posed by the COVID-19 excluding business development companies from the pandemic. Processes for cooperation and sharing accelerated and large accelerated filer definitions information, both during a crisis and for purposes in analogous circumstances. In addition, the of resolution planning, are set forth in cooperation amendments increase the transition thresholds for arrangements finalized in September 2020 that are accelerated and large accelerated filers becoming specific to the CMG. non-accelerated filers from $50 million to $60
Council Activities and Regulatory Developments 157 million, and for exiting large accelerated filer status of registered offerings that include these credit from $500 million to $560 million. enhancements, which could result in a lower cost of capital and an increased level of investor protection. On March 31, 2020, the SEC issued temporary final rules for Form ID filers and for issuers subject On May 7, 2020, the SEC issued a temporary to reporting obligations pursuant to Regulation final rule to facilitate capital formation for small Crowdfunding and Regulation A in order to address businesses impacted by COVID-19. Specifically, the the needs of companies directly or indirectly rule is intended to expedite the offering process for affected by COVID-19. The temporary final smaller, previously established companies directly or rules provide temporary relief from the Form ID indirectly affected by COVID-19 that are seeking to notarization process for certain filers and extend meet their funding needs through the offer and sale the filing deadlines for specified reports and forms of securities pursuant to Regulation Crowdfunding. due pursuant to Regulation Crowdfunding and The temporary final rule is designed to facilitate this Regulation A for certain issuers. On the same day, offering process by providing tailored, conditional the SEC proposed amendments to facilitate capital relief from certain requirements of Regulation formation and increase opportunities for investors Crowdfunding relating to the timing of the offering by expanding access to capital for entrepreneurs and the availability of financial statements required across the United States. Specifically, the proposed to be included in issuers’ offering materials, while amendments are intended to simplify, harmonize, retaining appropriate investor protections. and improve certain aspects of the exempt offering framework to promote capital formation while On May 13, 2020, the SEC issued a proposed new preserving or enhancing important investor rule (rule 2a-5) under the Investment Company protections. The proposed amendments seek Act of 1940 (Investment Company Act) that would to address gaps and complexities in the exempt address valuation practices and the role of the offering framework that may impede access to board of directors with respect to the fair value of investment opportunities for investors and access to the investments of a registered investment company capital for issuers. or business development company. The proposed rule would provide requirements for determining On April 20, 2020, the SEC issued a final rule that fair value in good faith with respect to a fund for amends the financial disclosure requirements for purposes of section 2(a)(41) of the Investment guarantors and issuers of guaranteed securities Company Act. This determination would involve registered or being registered, and issuers’ affiliates assessing and managing material risks associated whose securities collateralize securities registered or with fair value determinations; selecting, applying, being registered in Regulation S-X to improve those and testing fair value methodologies; overseeing requirements for both investors and registrants. and evaluating any pricing services used; adopting The changes are intended to provide investors with and implementing policies and procedures; and material information regarding the specific facts maintaining certain records. The proposed rule and circumstances, make the disclosures easier to would permit a fund’s board of directors to assign understand, and reduce the costs and burdens to the fair value determination to an investment registrants. In addition, by reducing the costs and adviser of the fund, who would then carry out these burdens of compliance, issuers may be encouraged functions for some or all of the fund’s investments. to offer guaranteed or collateralized securities This assignment would be subject to board oversight on a registered basis, thereby affording investors and certain reporting, recordkeeping, and other protection they may not be provided in offerings requirements designed to facilitate the board’s conducted on an unregistered basis. Finally, by ability to effectively oversee the adviser’s fair value making it less burdensome and less costly for determinations. The proposed rule would include issuers to include guarantees or pledges of affiliate a specific provision related to the determination of securities as collateral when they structure debt the fair value of investments held by unit investment offerings, the revisions may increase the number trusts, which do not have boards of directors. The
158 2020 FSOC // Annual Report proposed rule would also define when market Act that prescribes the method by which certain quotations are readily available under section 2(a) investment companies (including mutual funds) (41) of the Investment Company Act. If rule 2a-5 is calculate and pay registration fees. adopted, the SEC would rescind previously issued guidance on the role of the board of directors in On October 9, 2020, the SEC issued a final rule determining fair value and the accounting and amending the definition of “accredited investor” auditing of fund investments. in its rules to add new categories of qualifying natural persons and entities, and to make certain On June 1, 2020, the SEC issued a final rule that other modifications to the existing definition. The modifies the registration, communications, and amendments are intended to update and improve offering processes for business development the definition to identify more effectively investors companies (BDCs) and other closed-end investment that have sufficient knowledge and expertise to companies under the Securities Act of 1933. As participate in investment opportunities that do directed by Congress, the SEC adopted rules not have the rigorous disclosure and procedural that allow these investment companies to use the requirements, and related investor protections, securities offering rules that are already available provided by registration under the Securities Act to operating companies. These rules will extend to of 1933. The SEC also adopted amendments to the closed-end investment companies offering reforms “qualified institutional buyer” definition in Rule currently available to operating company issuers by 144A under the Securities Act to expand the list expanding the definition of “well-known seasoned of entities that are eligible to qualify as qualified issuer” to allow these investment companies to institutional buyers. qualify; streamlining the registration process for these investment companies, including the process 4.4.3 Accounting Standards for shelf registration; permitting these investment On June 1, 2020, the OCC, Federal Reserve, FDIC, companies to satisfy their final prospectus delivery and NCUA issued a joint policy statement on requirements by filing the prospectus with the allowances for credit losses (ACLs), in response to SEC; and permitting additional communications changes to the U.S. generally accepted accounting by and about these investment companies during principles (GAAP), as promulgated by the Financial a registered public offering. In addition, the SEC Accounting Standards Board (FASB) Accounting amended certain rules and forms to tailor the Standards Update 2016-13 (CECL) and subsequent disclosure and regulatory framework to these amendments issued since June 2016. These changes investment companies. These amendments also are codified in Accounting Standards Codification modernize the SEC’s approach to securities (ASC) Topic 326. This interagency policy statement registration fee payment by requiring closed-end describes the measurement of expected credit losses investment companies that operate as “interval under the CECL methodology and the accounting funds” to pay securities registration fees using the for impairment on available-for-sale debt securities same method as mutual funds and exchange-traded in accordance with ASC Topic 326; the design, funds and extend the ability to use this payment documentation, and validation of expected credit method to issuers of certain continuously offered, loss estimation processes, including the internal exchange-traded products. The final rule expands controls over these processes; the maintenance of the ability of certain registered closed-end funds or appropriate ACLs; the responsibilities of boards of BDCs that conduct continuous offerings to make directors and management; and examiner reviews of changes to their registration statements on an ACLs. immediately effective basis or on an automatically effective basis after a set period of time after filing. On September 15, 2020, Treasury released a study The final rule also sets forth certain structured data on the need, if any, for changes to regulatory capital reporting requirements, including for filings on requirements necessitated by CECL as required the form providing annual notice of securities sold by Congress. The study found that a definitive pursuant to the rule under the Investment Company assessment of the impact of CECL on regulatory
Council Activities and Regulatory Developments 159 capital is not currently feasible, in light of the asset service providers. The United States had state of CECL implementation across financial joined Switzerland as one of the first countries to institutions and current market dynamics. Treasury voluntarily submit to an assessment of its compliance also stated it will continue to actively monitor with the new standards. The results of the FATF’s CECL implementation and consult with relevant findings will be published after they go through stakeholders, including the prudential regulators, the FATF’s quality and consistency process. FASB, and the SEC. FATF announced a second 12-month review for completion in 2021 and committed to providing On September 30, 2020, the OCC, Federal Reserve, updated guidance on virtual assets, including and FDIC issued a final rule delaying the estimated AML/CFT and counter-proliferation financing impact on regulatory capital stemming from the implications of so-called “stablecoins.” FATF also implementation of CECL. The final rule provides called on its members to tackle new threats and banking organizations that implement CECL during vulnerabilities posed by criminals during the the 2020 calendar year the option to delay for two COVID-19 crisis. years an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s 4.5 Mortgages and Consumer Protection effect on regulatory capital, followed by a three-year transition period. The agencies provided this relief 4.5.1 Mortgages and Housing Finance to allow these banking organizations to better focus On April 3, 2020, the CFPB, Federal Reserve, on supporting lending to creditworthy households FDIC, NCUA, OCC, and CSBS issued a joint and businesses while also maintaining the quality of policy statement providing regulatory flexibility to regulatory capital. enable mortgage servicers to work with struggling consumers affected by COVID-19. Under the CARES 4.4.4 Bank Secrecy Act/Anti-Money Laundering Act, borrowers in a federally backed mortgage loan Regulatory Reform experiencing financial hardship due, directly or On February 21, 2020, the Financial Action Task indirectly, to COVID-19, may submit a forbearance Force (FATF), an international intergovernmental request to their mortgage servicer. In response, organization that developed international standards servicers must provide a CARES Act forbearance for combating money laundering and the financing that allows borrowers to defer their mortgage of terrorism and proliferation of weapons of mass payments for up to 180 days with the possibility of destruction, released guidance on the issue of an extension of up to another 180 days. The policy digital identity for customer identification and statement states that the agencies do not intend verification. This guidance explains how digital ID to take supervisory or enforcement action against systems could meet FATF’s customer due diligence mortgage servicers for delays in sending certain standards and will assist governments and financial early intervention and loss mitigation notices, institutions worldwide to apply a risk-based approach provided that servicers make good faith efforts to to using digital ID systems. The FATF also discussed do so within a reasonable time. The joint statement the changes made by the United States to improve clarifies the application of the Regulation X (which the anti-money laundering (AML)/countering the implements the Real Estate Settlement Procedures financing of terrorism (CFT) system since the 2016 Act) mortgage servicing rules to CARES Act Mutual Evaluation Report, including Treasury’s forbearance and describes the agencies’ flexible Customer Due Diligence rulemaking and beneficial approach to supervision and enforcement with ownership requirements that went into effect in respect to certain Regulation X provisions that 2018. require consumer notices and loss mitigation provisions. The CFPB released a set of FAQs to In July 2020, the FATF completed a 12-month provide additional compliance guidance. review on the state of implementation of standards that were revised in June 2019 to explicitly impose On April 17, 2020, the OCC, Federal Reserve, and AML/CFT obligations on virtual assets and virtual FDIC issued an interim final rule to temporarily
160 2020 FSOC // Annual Report amend the agencies’ regulations requiring percent. The final rule also establishes a separate appraisals and evaluations for certain real estate small member participation housing goal with a loan transactions. The interim final rule defers the target level of 50 percent. It provides that a bank requirement to obtain an appraisal or evaluation may request FHFA approval of alternative target for up to 120 days following the closing of a levels for either or both of the goals. The final rule transaction for certain residential and commercial also establishes that housing goals apply to each real estate transactions, excluding transactions for bank that acquires any Acquired Member Assets acquisition, development, and construction of real mortgages during a year, eliminating the existing estate. The rule states that regulated institutions $2.5 billion volume threshold that previously should make best efforts to obtain a credible triggered the application of housing goals for each valuation of real property collateral before the loan Bank. Enforcement of the final rule will phase in closing, and otherwise underwrite loans consistent over three years. with the principles in the agencies’ Standards for Safety and Soundness and Real Estate Lending On June 26, 2020, the CFPB published a final Standards. The agencies provided this relief to interpretive rule on Regulation Z. The CFPB allow regulated institutions to expeditiously extend produces annually a list of rural and underserved liquidity to creditworthy households and businesses counties and areas that is used in applying various in light of recent strains on the U.S. economy due Regulation Z provisions, such as the exemption to COVID-19. The provisions of the interim final from the requirement to establish an escrow account rule expire on December 31, 2020. The agencies for a higher-priced mortgage loan and the ability finalized the interim final rule by issuing a final rule to originate balloon-payment qualified mortgages. on October 16, 2020. The final rule adopted the Regulation Z states that an area is “underserved” interim final rule without substantive changes. The during a calendar year if, according to HMDA data final rule became effective on October 16, 2020. The for the preceding calendar year, it is a county in NCUA issued a substantially similar interim final which no more than two creditors extended covered rule on April 21, and together the agencies issued transactions, as defined in Regulation Z, secured a joint statement outlining additional flexibilities by first liens on properties in the county five or around appraisal standards. more times. The official commentary provides an interpretation relating to this standard that refers to On May 12, 2020, the CFPB issued a final rule certain data elements from the previous version of amending Regulation C, which implemented the CFPB’s Regulation C, which implements HMDA, the Home Mortgage Disclosure Act (HMDA), to which were modified or eliminated in the 2015 increase the threshold for reporting data about amendments to Regulation C. The CFPB issued this closed-end mortgage loans, so that institutions interpretive rule to specifically describe the HMDA originating fewer than 100 closed-end mortgage data that will instead be used in determining that an loans in either of the two preceding calendar years area is “underserved.” do not have to report such data effective July 1, 2020. The CFPB also set the threshold for reporting On June 30, 2020, the FHFA issued a revised NPRM data about open-end lines of credit at 200 open-end and request for comment on a new regulatory lines of credit effective January 1, 2022, upon the capital framework for Fannie Mae and Freddie Mac expiration of the current temporary threshold of that would amend definitions in FHFA’s regulations 500 open-end lines of credit. for assessments and minimum capital. The proposed rule would also remove the Office of Federal On June 25, 2020, the FHFA issued a final rule Housing Enterprise Oversight’s previous regulation amending the existing Federal Home Loan Bank on capital for the Enterprises. Housing Goals regulation. The final rule replaces the existing regulation’s four separate retrospective On June 30, 2020, the CFPB issued an interim final housing goals with a single prospective mortgage rule amending Regulation X to temporarily permit purchase housing goal with a target level of 20 mortgage servicers to offer certain loss mitigation
Council Activities and Regulatory Developments 161 options based on the evaluation of an incomplete For General QM loans, the ratio of the consumer’s loss mitigation application. Eligible loss mitigation total monthly debt to total monthly income (DTI options, among other things, must permit ratio) must not exceed 43 percent. In the NPRM borrowers to delay paying certain amounts until related to the General QM loan definition, the the mortgage loan is refinanced, the mortgaged CFPB proposed, among other things, to remove property is sold, the term of the mortgage loan the General QM loan definition’s 43 percent DTI ends, or, for a mortgage insured by the FHA, the limit and replace it with price-based thresholds. mortgage insurance terminates. These amounts The objective of the NPRMs is to facilitate a smooth include, without limitation, all principal and interest and orderly transition away from the Temporary payments forborne through payment forbearance GSE QM loan definition and to ensure access to programs made available to borrowers experiencing responsible, affordable mortgage credit upon its financial hardships due, directly or indirectly, to expiration. the COVID-19 emergency, including the payment forbearance program offered pursuant to section On July 22, 2020, the CFPB issued an NPRM that 4022 of the CARES Act. These amounts also include would amend Regulation Z to exempt certain principal and interest payments that are due and insured depository institutions and insured credit unpaid by these borrowers. unions from the requirement to establish escrow accounts for certain higher-priced mortgage loans. On July 10, 2020, the CFPB issued two NPRMs that would amend certain definitions of qualified On August 28, 2020, the CFPB issued an NPRM mortgages (QMs) in Regulation Z. Regulation Z proposing to create a new category of QMs generally requires creditors to make a reasonable, (Seasoned QMs) for first-lien, fixed-rate covered good faith determination of a consumer’s ability to transactions that have met certain performance repay any residential mortgage loan, and loans that requirements over a 36-month seasoning period, meet Regulation Z’s requirements for QMs obtain are held in portfolio until the end of the seasoning certain protections from liability. There are several period, comply with general restrictions on product different categories of QMs, including Temporary features and points and fees, and meet certain Government Sponsored Enterprise (GSE) QM underwriting requirements. The CFPB’s primary loans and General QM loans. Temporary GSE QM objective with this NPRM is to ensure access to loans include loans that are eligible for purchase responsible, affordable mortgage credit by adding or guarantee by either of the Enterprises, while a Seasoned QM definition to the existing QM operating under the conservatorship or receivership definitions. of the FHFA. The Enterprises are currently under Federal conservatorship. The CFPB established In September 2020, CSBS issued for public comment the Temporary GSE QM loan definition as a proposed regulatory prudential standards for temporary measure that is set to expire no later nonbank mortgage servicers subject to licensing than January 10, 2021 or when the Enterprises exit and supervision by state financial regulators. The conservatorship, whichever occurs first. proposed standards include baseline prudential standards that cover eight areas, including capital, In one NPRM released on July 10, 2020, the CFPB liquidity, risk management, data standards proposed to extend the Temporary GSE QM loan and integrity, data protection (including cyber definition to expire upon the effective date of final risk), corporate governance, servicing transfer amendments to the General QM loan definition requirements, and change of control requirements. (or when the Enterprises cease to operate under The capital and liquidity components of the the conservatorship of the FHFA, if that happens baseline standards would be consistent with the earlier). The final rule extending the Temporary minimum financial eligibility requirements imposed QM loan definition was issued October 26, 2020. on nonbank seller/servicers by the Enterprises. The other NPRM issued on July 10, 2020 proposed Additionally, the proposed standards include amendments to the General QM loan definition. enhanced prudential standards which would apply
162 2020 FSOC // Annual Report higher capital and liquidity requirements as well will neither cite supervisory violations nor initiate stress testing and resolution planning requirements enforcement actions against insured institutions for on certain, large complex servicers. continuing to provide estimates to consumers under the temporary exception, instead of actual amounts. 4.5.2 Consumer Protection On May 21, 2020, the CFPB extended the comment On July 21, 2020, the CFPB issued a final rule period for a supplemental NPRM regarding time- amending its regulations governing payday, vehicle barred debt. The CFPB proposed to prohibit debt title, and certain high-cost installment loans. collectors from using non-litigation means (such Specifically, the CFPB revoked several provisions as calls) to collect on time-barred debt unless of those regulations, including ones that provide collectors disclose to consumers during the initial that it is an unfair and abusive practice for a lender contact and on any required validation notice to make a covered short-term or longer-term that the debt is time-barred. Consumer research balloon-payment loan, including payday and vehicle conducted by the CFPB found that a time-barred title loans, without reasonably determining that debt disclosure helps consumers understand that consumers have the ability to repay those loans they cannot be sued if they do not pay, helping according to their terms; prescribe mandatory consumers make better informed decisions about underwriting requirements for making the ability- whether to pay the debt. to-repay determination; and exempt certain loans from the mandatory underwriting requirements. On May 22, 2020, the CFPB issued a no-action letter The CFPB made these amendments to the (NAL) template that insured depository institutions regulations based on its re-evaluation of the legal can use to apply for a NAL covering their small- and evidentiary bases for these provisions. The final dollar credit products. The NAL template includes rule did not amend the provisions of the regulations protections for consumers who seek small-dollar that impose certain requirements on providers loan products. that obtain authorization to initiate payment withdrawals, including prohibiting such withdrawals On June 5, 2020, the CFPB issued a final after two failed attempts without a new and specific rule amending the remittance rule. The Electronic authorization, and disclosures related to payment Fund Transfer Act, as amended by the Dodd- practices. Frank Act, establishes certain protections for consumers sending international money transfers, 4.6 Data Scope, Quality, and Accessibility or remittance transfers. The CFPB’s remittance rule in Regulation E implements these protections. 4.6.1 Data Scope The CFPB amended Regulation E and the official Expansion of LEI Adoption interpretations of Regulation E to provide tailored During the past year, global adoption of the Legal exceptions to address compliance challenges that Entity Identifier (LEI) of the Global LEI System insured depository institutions may face in certain continued to expand. As of September 30, 2020, circumstances upon the expiration of a statutory more than 1.7 million LEIs had been issued by 36 exception that allows insured depository institutions approved operational issuers. Approximately 34 to disclose estimates instead of exact amounts to percent of these were issued in the United States, consumers. The amendments to Regulation E and approximately 13 percent were issued to U.S.- became effective on July 21, 2020, the same day based entities. The total number of LEIs issued the statutory exception expired. The CFPB also represents a year-to-date increase of 9 percent, increased a safe harbor threshold related to whether which follows the 9 percent increase in 2019. a person makes remittance transfers in the normal course of its business. On April 10, 2020, the CFPB This expansion continues to be driven primarily by issued a policy statement that for international the LEI’s use in financial regulation, particularly remittance transfers that occur on or after July in the European Union. Beginning in January 21, 2020 and before January 1, 2021, the CFPB 2018, EU regulations under the revised Markets in
Council Activities and Regulatory Developments 163 Financial Instruments Directive (MiFID II) required is sufficient for use by industry participants and entities involved in securities and Over-the-Counter regulators. (OTC) derivatives transactions to have an LEI and to use that LEI when reporting these transactions. Updated LEI Standard Future expansion could also be supported by the This past year, the International Organization growing interest of some large financial institutions for Standardization (ISO) completed a five-year in utilizing the LEI for purposes other than systematic review of ISO 17442 (i.e., the ISO regulatory compliance and reporting. In the future, standard on which the Global LEI System is based) such expansion could lead in turn to the LEI being and published an updated version of this standard. used (or evaluated for use) more extensively outside Council members contributed to this review in a of the financial industry. Further use of the LEI variety of ways. in financial regulation can be expected to lead to modest future global increases in the number of Expanded Role of the LEI ROC LEIs issued. This past year, the LEI ROC conducted due diligence and related work that led to its decision to Improving LEI Data Quality take on the role of international governance body Improving the quality of LEI data is important to for new regulatory financial data standards for OTC building market confidence and the utility of the derivative transaction reporting, which standards LEI. Therefore, considerable attention is directed had earlier been promulgated by the Committee on to this challenge by the Council members that Payments and Market Infrastructures-International are represented on the Legal Entity Identifier Organization of Securities Commissions (CPMI- Regulatory Oversight Committee (LEI ROC), IOSCO) and the FSB. These standards are the including the OFR, SEC, CFTC, CFPB, FDIC, OCC, Unique Transaction Identifier (UTI), the Unique and the Federal Reserve. The LEI ROC is a group Product Identifier (UPI), and the Critical Data of more than 60 regulatory authorities from around Elements (CDE). The LEI ROC agreed to take the world that oversee the Global LEI Foundation on this new role following the review of the work (GLEIF). The GLEIF is a not-for-profit organization of its Working Group on Governance of Unique that serves as the Global LEI System’s central Identifiers and Data Elements. That work, in key operating unit and ensures the system’s operational parts, was performed in collaboration with the integrity. Working Group on UTI and UPI Governance (GUUG) of the FSB. On October 1, 2020, after One area of particular interest to these Council having obtained the approval of the LEI ROC and members is the ongoing work on “Level 2” LEI FSB, the LEI ROC assumed the role of international data – i.e., data submitted by legal entities acquiring governance body for the UTI, UPI, and CDE. an LEI regarding their “direct accounting consolidating parent” and their “ultimate 4.6.2 Data Quality accounting consolidating parent.” Level 2 LEI data Reporting of Standardized Derivatives Data allows parties to a financial transaction to use LEIs In 2020, Council members continued to participate to identify not just the counterparties with whom in the development of international regulatory they are transacting, but also affiliated entities, and industry standards for the reporting of OTC thereby improving the ability of such entities derivatives transactions. A key milestone reached to perform a risk assessment of the transaction during the year was the approval of the UTI as counterparties. a new ISO standard (ISO 23897), with support and input from Council members. This industry This past year, the LEI ROC continued to focus on standard is now available for global application. improving the quality of Level 2 LEI data, as well as Because this industry standard is expected to be other elements of LEI reference data. The Council is used by regulators in multiple jurisdictions in their committed to serving on the LEI ROC and working respective OTC derivative transaction reporting with the GLEIF to ensure the quality of LEI data regimes, the UTI will improve the abilities of
164 2020 FSOC // Annual Report firms and regulators to monitor these financial transactions across borders.
Another milestone reached during 2020 was an agreement by ISO to initiate development work on a new ISO standard for the UPI. Council members contributed to the submission to ISO on UPI. This development work is expected to continue into 2021. The UPI will allow derivatives regulators and other government agencies to better monitor emerging financial risks by categorizing different types of derivatives transactions. The Derivatives Service Bureau (DSB), a subsidiary of the Association of National Numbering Agencies, will act as the UPI Service Provider (i.e., it will receive and store product attributes and assign UPI codes to OTC derivatives products).
In 2020 Council members participated in a Joint Small Group of FSB GUUG and LEI ROC to refine DSB governance and to continue refinement of regulatory technical standards for CDE beyond those developed by CPMI-IOSCO. Like the UTI and UPI, the CDE are expected to be used by regulators in multiple jurisdictions in their respective OTC derivative transaction reporting regimes. It is expected these data elements will be submitted to ISO as business concepts or business elements within the ‘data dictionary’ of the ISO 20022 standard. Council members are participating in preparatory work for this submission, which is being conducted in partnership with the Society for Worldwide Interbank Financial Telecommunications (SWIFT), the Registration Authority for ISO 20022.
Council Activities and Regulatory Developments 165
Potential Emerging Threats, Vulnerabilities, 5 and Council Recommendations
The outbreak of the COVID-19 pandemic is bankruptcy filings are approaching cyclical highs the biggest external shock to hit the post-war and are likely to increase until a full recovery takes U.S. economy. As businesses and establishments hold (see Box A). shut down in March and April, private-sector employment declined by almost a fifth. The A large wave of bankruptcies could stress resources implementation of the CARES Act and a series at courts and make it harder for firms to obtain of policy measures taken by the Federal Reserve critical debtor-in-possession financing, which and Treasury helped stabilize financial markets. could preclude timely debt restructuring for many Although these policy measures have rejuvenated firms, potentially forcing them into liquidation. credit markets, a protracted outbreak can adversely In comparison to debt restructurings, liquidations affect any recovery and prolong the downturn. This typically lead to greater economic losses from section presents a general discussion of identified the ensuing declines in employment and capital vulnerabilities in the context of the COVID-19 stress, spending. Moreover, creditors may suffer bigger highlights key actions taken to mitigate risks, and losses from liquidation, potentially contributing to a makes recommendations for addressing the risks. further tightening in overall credit conditions.
5.1 Nonfinancial Business: Corporate Credit Elevated valuations in U.S. equities and corporate bonds make these markets vulnerable to a major Low interest rates after the 2008 financial crisis repricing of risk, increasing volatility, and weakening fueled a prolonged credit expansion in nonfinancial balance sheets of financial and nonfinancial business. Since 2011, the rate of growth in corporate businesses. Sharp reductions in the valuations of borrowing has exceeded the growth in nominal different assets could negatively impact liquidity, GDP, pushing the corporate debt-to-GDP ratio to increase borrowing costs, and heighten rollover risk. historic highs when the pandemic hit the United States (see Section 3.2.1). As credit conditions Despite the turmoil in credit markets, the policy- deteriorated in March, market financing dried up aided rebound in business financing has been strong significantly. Bank credit lines became the principal and the ratio of corporate debt-to-GDP has reached source of funding for most businesses, especially new record highs. The potential risk to financial those adversely affected by the pandemic (see stability from nonfinancial business borrowing Section 3.5.1). depends on the ability of businesses to service their obligations, the ability of the financial sector to Rapid and decisive intervention by the Federal absorb losses from defaults and downgrades, and Reserve and Treasury in March helped generate the continued willingness of market participants a rebound in debt financing and revived investor to provide intermediation during times of stress. sentiment. Since then, principal equity indices have In the years prior to the pandemic, the increase in broken through to historic highs, while spreads in business debt did not fuel increased investments commercial paper and bond financing have also to strengthen corporations’ earnings potential, returned to near pre-pandemic lows. leaving them vulnerable to debt servicing problems. Moreover, debt overhang problems could lead to Meanwhile, banks have tightened standards on a sluggish recovery. In extreme situations when new lending. Since March, nearly $2 trillion in debt servicing problems are widespread, credit nonfinancial corporate debt has been downgraded markets remain vulnerable to a repricing of risk and and default rates on leveraged loans and corporate disruptions to financial stability. bonds have increased considerably. Business
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 167 Recommendations so-called “first-mover advantage,” where investors The Council recommends that agencies continue believe they will be better off if they redeem faster to monitor levels of nonfinancial business leverage, than other investors. trends in asset valuations, and potential implications for the entities they regulate in order to assess As prime MMFs experienced heavy redemptions, and reinforce the ability of the financial sector to their WLAs dropped notably, and some funds’ manage severe, simultaneous losses. Regulators and WLAs (which must be disclosed publicly each market participants should continue to monitor and day) approached or fell below the 30 percent analyze the exposures, loss-absorbing capacity, and minimum threshold required by SEC rules. When incentives of different types of stakeholders. This a fund’s WLA falls below 30 percent, the fund includes the direct and indirect exposures of holders board can impose fees or gates on redemptions. of U.S. nonfinancial corporate credit, the effects of Market participants reported concerns that the potential liquidity risks in certain mutual funds, the imposition of a fee or a gate by one fund could spark effects of evolving loan covenant and documentation widespread redemptions from others. Preliminary requirements, and the potential effects of mark- research indicates that prime fund outflows to-market losses and credit rating downgrades, accelerated as WLAs fell close to 30 percent. among other considerations. Regulators and market participants should also continue to assess ways in Among institutional and retail prime MMFs, the which leveraged nonfinancial corporate borrowers scale of the outflows as a percentage of fund assets and elevated asset prices may amplify stresses in the exceeded those that occurred during the September broader market in the event of a rapid repricing of 2008 crisis, while the scale for tax-exempt funds risk or a slowdown in economic activity. was similar to that in the 2008 financial crisis (see Box D). Outflows abated after the Federal Reserve’s 5.2 Financial Markets announcement of support for MMFs in mid-to-late March. 5.2.1 Short-Term Wholesale Funding Markets In normal times, wholesale funding markets provide Repo Market essential short-term funding to businesses, local Repo markets have undergone significant structural governments, and other financial intermediaries changes since the 2008 financial crisis. These (see Sections 3.4.1 and 3.4.2). In addition to changes helped streamline some repo operations government entities and the Federal Reserve, and reduced exposures to counterparty risk. Repo domestic participants in these markets include markets remain critical not only to financial stability broker-dealers, banks, money funds, hedge funds, but also to the implementation of monetary policy, and securities lenders (see Box D). Developments and these linkages were highlighted by the turmoil in the STFMs can have implications for financial in repo markets in mid-September 2019. stability, as well as for the implementation of monetary policy. Overnight repo rates spiked in mid-September 2019, with SOFR increasing by approximately 300 basis Money Market Mutual Funds points (see Section 3.4.2). This unexpected high Stresses on prime and tax-exempt MMFs revealed volatility has been attributed to technical factors (for continued structural vulnerabilities that led to example, to finance new Treasury settlements) and a increased redemptions and, in turn, contributed decline in funds available from banks and MMFs, as to and increased the stress in short-term funding corporations made quarterly tax payments. However, markets (see Section 3.5.2.3). MMFs offer the repo volatility spilled over to other short-term shareholders redemptions on a daily basis (and rates, including the effective federal funds rate. The retail at a stable NAV), while many of the short- Federal Reserve restored control of the policy rate term instruments that the MMFs hold may not be by injecting reserves, and the FOMC announced its liquid in times of stress. This liquidity difference intention to maintain an ample supply of reserve contributes to redemption incentives including a
168 2020 FSOC // Annual Report balances to aid the orderly functioning of funding and tax-exempt MMFs (as well as other short- markets. term funds with similar characteristics, such as short-term collective investment funds), and any Repo rates on Treasuries and agency MBS spiked role that leveraged nonbank entities may have once again in mid-March 2020. Selling pressures played in the repo market, and, if warranted, take in Treasuries likely originated from foreign central appropriate regulatory measures to mitigate these banks and foreign investors seeking dollar funding vulnerabilities. during the pandemic. Liquidity demand from leveraged participants, such as hedge funds using 5.2.2 Residential Real Estate Market: Nonbank Treasury collateral (see Section 3.5.2.5 and Box Mortgage Origination and Servicing B), and mREITs using agency MBS collateral (see Nonbank mortgage companies play a significant Section 3.5.2.2), may have also played a significant role in the housing finance system (see Section role. These leveraged participants are vulnerable to 3.4.5). Nonbanks originated nearly 60 percent funding risks because of their reliance on short-term of new mortgages in 2019 and service nearly repo funding. When these leveraged participants half of all mortgage debt outstanding. They are face margin calls (either because of an external particularly important for helping extend credit shock to the repo market or investor concerns about to low- and moderate-income borrowers and have their profitability), the need to deleverage can provided competition and liquidity in the market increase selling pressures and lead to more margin for mortgage servicing rights. While the business calls. Since the assets on their balance sheet are the models of nonbank mortgage companies vary, same assets used as collateral in their repo funding, many are subject to certain fragilities, such as a the pressure to deleverage can create an adverse heavy reliance on short-term funding, obligations feedback loop of increased selling pressures and to continue to make servicing advances for certain more margin calls. The complexity of interactions delinquent borrowers, and limited resources to involving leveraged participants raises concerns as to absorb adverse economic shocks. Given these their role in amplifying funding stresses. fragilities and their connections to other markets and market participants, nonbanks could transmit Recommendations risk to the broader financial system should they Recent market stresses, including the financial experience financial stress. fallout from the pandemic, have confirmed that there remain potentially significant structural As the shock from the pandemic hit the United vulnerabilities in short-term funding markets. States, federal and state governments enacted Market participants that rely predominantly on a series of public assistance policies to aid short-term debt are vulnerable to funding risks. homeowners, such as suspending foreclosures, For banks and other depository institutions, this placing a moratorium on evictions, and offering risk is mitigated by deposit insurance and liquidity flexibilities in home purchase and mortgage backstops, such as the Federal Reserve’s discount acquisition processes. Under the CARES Act, window. However, non-depository institutions borrowers with a federally backed mortgage are able are also important participants in these markets. to request mortgage payment forbearance. Leveraged nonbank participants that depend on short-term funding also can pose a challenge to An increase in forbearance and default rates has the financial stability. If their short-term funding is potential to impose significant strains on nonbank not rolled over, these entities can be forced to servicers, but nonbanks have generally continued deleverage, and that can create an adverse feedback to meet their servicing obligations. Increased loop of asset sales and margin calls. originations, beneficial policy actions, and fiscal stimulus have mitigated nonbanks’ potential credit The Council recommends that regulators review and liquidity pressures. The surge in refinancing these structural vulnerabilities, including the due to low rates has provided servicers with an vulnerability of large-scale redemptions in prime additional source of liquidity to help sustain
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 169 operations. In addition, federal agencies have issued guidance and provided clarification on servicer advance obligations that, in some cases, limited the duration of required advances. Ginnie Mae established a liquidity facility for its servicers that provides a last resort financing option, though that facility has seen limited uptake. Government stimulus programs and expanded unemployment insurance may have averted additional delinquencies and limited forbearance requests, relieving some potential stress on servicers. As the economy recovers, the Council will continue to monitor closely the origination and servicing markets and the condition of nonbank mortgage companies.
Recommendations The Council recommends that relevant federal and state regulators continue to coordinate closely to collect data, identify risks, and strengthen oversight of nonbank companies involved in the origination and servicing of residential mortgages. Regulators and market participants have taken steps to address the potential risks stemming from nonbanks, including additional collaboration and the proposed strengthening of prudential requirements. The Council encourages regulators to take additional steps available to them within their jurisdictions to address the potential risks of nonbank mortgage companies. While nonbank mortgage originators have experienced enhanced profitability during the refinance boom, relevant regulators should ensure that the largest and most complex nonbank mortgage companies are prepared should refinances decrease or forbearance rates increase. In addition, the Council recommends that relevant federal and state regulators develop and establish an information-sharing framework to enable collaboration and communication in responding to distress at a mortgage servicer. Regulators should also develop and implement coordinated resolution planning requirements for large and complex nonbank mortgage companies.
170 2020 FSOC // Annual Report Box F: Council Statement on Activities-Based Review of Secondary Mortgage Market Activities
On September 25, the Council issued a statement Enterprise is capitalized to remain a viable going on its activities-based review of secondary mortgage concern both during and after a severe economic market activities. The Council’s review focused in downturn and also to mitigate the potential risk particular on the activities of Fannie Mae and Freddie to national housing finance markets posed by the Mac as the dominant private secondary market Enterprise. providers of liquidity through their purchase of In conducting its review, the Council considered the mortgages for securitization and sale as guaranteed following two questions, among others: MBS. In assessing potential risks to financial stability, the Council applied the framework for an activities- 1) Is the proposed capital rule appropriately sized based approach described in the interpretive guidance and structured given the Enterprises’ risks and on nonbank financial company determinations issued their key role in the housing finance system? by the Council in December 2019. 2) Does the proposed capital rule promote stability in The 2008 financial crisis demonstrated that financial the broader housing finance system? stress at the Enterprises could limit their ability to Based on its assessment of the proposed rule, provide reliable liquidity to the secondary market the statement issued by the Council contained the or perform their guarantee and other obligations following key findings: on their MBS and other liabilities, with significant First, with respect to Risk-Based Capital implications for the national housing finance markets, Requirements: The proposed rule includes a risk- financial stability, and the broader economy. The sensitive capital framework that results in a granular Enterprises continue to play a central role in the calibration of credit risk capital requirements. It would national housing finance markets—acquiring nearly require aggregate credit risk capital on mortgage 50 percent of newly originated mortgages in both exposures that, as of September 2019, would lead to single-family and multifamily markets—and are two of a substantially lower risk-based capital requirement the largest U.S. financial institutions, with significant than the bank capital framework, and likely be lower interconnectedness with financial markets and other than other credit providers across significant portions financial institutions. of the risk spectrum during much of the credit cycle. If the Enterprises were unable to provide liquidity This would create an advantage that could maintain to the secondary market, other market participants significant concentration of risk with the Enterprises. may be unable in the near- or medium-term to The Council encouraged FHFA and other regulatory provide liquidity at the scale and pricing needed agencies to coordinate and take other appropriate to ensure smooth market functioning and financial action to avoid market distortions that could intermediation. As a result, any distress at the increase risks to financial stability by generally taking Enterprises that affected their secondary mortgage consistent approaches to the capital requirements market activities, including their ability to perform their and other regulation of similar risks across market guarantee and other obligations on their MBS and participants, consistent with the business models and other liabilities, could pose a risk to financial stability, missions of their regulated entities. if risks are not properly mitigated. Second, on Capital Buffers: The proposed rule Capital is a core component of FHFA’s regulatory includes a stress capital buffer and a stability capital framework. Therefore, in assessing potential risk buffer that would require the Enterprises to hold mitigants, much of the Council’s analysis focused on capital above their regulatory requirements. The a new capital regulation recently proposed by FHFA. inclusion of such capital buffers is an important step This proposal is intended to enhance the quality and to mitigating the risks the Enterprises pose to the quantity of required capital, so as to ensure that each
Box F: Council Statement on Activities-Based Review of Secondary Mortgage Market Activities 171 Box F: Council Statement on Activities-Based Review of Secondary Mortgage Market Activities
broader system. The calibration of the buffers in the and satisfy their obligations during and after a period proposed rule might help achieve certain policy goals, of severe stress. However, the Council’s analysis using such as reducing the buffers’ impact on higher risk benchmark comparisons suggested that risk-based exposures, but is based on total adjusted assets, not capital requirements and leverage ratio requirements risk-weighted assets, and thus may be relatively risk- that are materially less than those contemplated by insensitive. the proposed rule would likely not adequately mitigate For that reason, the Council encouraged FHFA to the potential stability risk posed by the Enterprises. consider the relative merits of alternative approaches Moreover, it is possible that additional capital could be for more dynamically calibrating the capital buffers. required for the Enterprises to remain viable concerns The capital buffers should be tailored to mitigate in the event of a severely adverse stress, particularly if the potential risks to financial stability and otherwise the Enterprises’ asset quality were ever to deteriorate ensure that the Enterprises have sufficient capital to to levels comparable to the experience leading up to absorb losses during periods of severe stress and the 2008 financial crisis. remain viable going concerns, while balancing other The Council thus encouraged FHFA to ensure high- policy objectives. quality capital by implementing regulatory capital Third, on Total Capital Sufficiency: The proposed rule definitions that are similar to those in the U.S. banking would increase the quality and quantity of capital that framework. The Council also encouraged FHFA to the Enterprises would be required to hold. Significant require the Enterprises to be sufficiently capitalized to high-quality capital would mitigate risks to financial remain viable as going concerns during and after a stability by making it more likely that the Enterprises severe economic downturn. will be able to perform their countercyclical function In addition to a capital framework, FHFA is also and maintain market confidence as viable going implementing significant additional enhancements to concerns through the economic cycle. Similarly, a the Enterprises’ regulatory framework that would help meaningful leverage ratio requirement that is a credible mitigate the potential risk to financial stability, thereby backstop to the risk-based requirements would enabling the Enterprises to provide secondary address potential risks to financial stability. market liquidity throughout the economic cycle. The proposed rule, by relying on definitions of These enhancements include efforts to strengthen regulatory capital that are similar to that of the U.S. Enterprise liquidity regulation, stress testing, banking framework, would ensure that high-quality supervision, and resolution planning. capital is the predominant form of regulatory capital. The Council supported FHFA’s commitment With respect to the quantity of regulatory capital, the to developing its broader prudential regulatory Council considered the proposed capital requirements framework for the Enterprises, and will continue to in light of a number of relevant benchmarks, such monitor the secondary mortgage market activities as: (1) losses during the 2008 financial crisis; (2) a of the Enterprises and FHFA’s implementation of comparison of the proposed capital requirements to the regulatory framework to ensure potential risks those of other large, complex financial institutions, to financial stability are adequately addressed. If taking into account differences in business models the Council determines that such risks to financial and risk profiles; and, (3) the capital requirements stability are not adequately addressed by FHFA’s implied by a conservative mortgage stress test model. capital and other regulatory requirements or other risk mitigants, the Council may consider more formal The proposed rule requires a meaningful amount of recommendations or other actions, consistent with capital for the Enterprises, and is a significant step the December 2019 guidance. towards ensuring that the Enterprises would be able to provide liquidity to the secondary mortgage market
172 2020 FSOC // Annual Report 5.2.3 Commercial Real Estate Market 5.3 Financial Institutions The COVID-19 pandemic led to the closure of many business establishments. While some of these 5.3.1 Large Bank Holding Companies closures have been temporary (such as restaurants), Large BHCs are critical to the U.S. financial others have been more long-lasting (such as system, performing essential banking functions entertainment parks and movie theaters). Although such as the provision of credit to commercial and the intensity and impact of closures depends on the retail borrowers. As the shock from the pandemic duration and strength of the pandemic, it raises has shown, bank credit lines provide a lifeline to concerns about the viability of several types of business, especially in times when nonbanks and business establishments and their ability to pay rent other market sources of finance tighten credit (see or generate income from commercial properties. Section 3.5.1.1). A prolonged downturn leaves the commercial real estate (CRE) sector vulnerable to mortgage default The central role that large BHCs play in retail and and decline in valuations, with spillovers to the wholesale payment systems ensure that operational broader economy (see Section 3.4.6). failures do not disrupt commercial activity even in times of market stress. Large BHCs also help There are two reasons why CRE is important to financial and nonfinancial firms to hedge their risk financial stability in the United States (see Box exposures in the derivatives markets. Lastly, several E). First, asset sales from financially distressed specialized financial services, such as tri-party individual properties can lower valuations, spilling repo and custody services for asset managers, are over into adjoining property values, leading to more concentrated in the largest BHCs. distress and a general downward spiral on CRE valuations. Second, a significant proportion of CRE The onset of the pandemic dried up funding loans is currently held on balance sheets of banks, from market and nonbank sources. Bank credit with small and mid-size banks more likely to be lines became the principal source of funding for concentrated in CRE. Distress in CRE properties corporations adversely affected by the pandemic. makes these creditor banks vulnerable to losses and The strengthened capital positions following write-downs, with the potential to tighten credit and the 2008 financial crisis helped banks withstand dampen the economic recovery. If these valuation large emergency credit drawdowns. Liquidity pressures and asset sales do not remain localized, a pressures were also eased when the Federal Reserve widespread decline in the valuation of underlying lowered the discount rate by 150 basis points, CRE properties could lead to sluggish economic encouraged discount borrowing, and announced growth. facility programs to aid banks and markets. Most corporations drew on their bank credit lines as a Recommendations precautionary measure and deposited the proceeds The Council recommends that regulators continue with banks. Bank deposits grew sharply not just from to monitor volatility in CRE asset valuations, the credit line withdrawals and payments from fiscal level of CRE concentration at banks, and the programs, but also because investors fleeing risky performance of CRE loans. Regulators should also assets sought the safety of insured deposits. These monitor exposures, loss-absorbing capacity, and the events underlined the critical role that the banking incentives of banks and other entities that hold CRE system plays in the provision of credit during loans, including REITs and insurance companies. episodes of financial distress. The Council recommends that regulators continue to encourage banks and other entities to bolster, The pandemic has significantly impaired the as needed, their loss absorption capacity by ability of some households and businesses to repay strengthening their capital and liquidity buffers debt. However, mortgage forbearance, interagency commensurate with the levels of CRE concentration guidance on troubled debt restructurings, and on their balance sheets. various liquidity support programs have helped mitigate some of these pressures. As a result,
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 173 delinquency rates on bank loans for the first half of and developing plans for recovery and orderly 2020 remain low and have yet to reveal a significant resolution. deterioration in loan performance. Meanwhile, large BHCs have significantly increased loan The Council recommends that financial regulators loss provisions in anticipation of the impending ensure that the largest financial institutions deterioration in asset quality. Loan loss provisions maintain sufficient capital and liquidity to ensure were also affected by the adoption of the CECL their resiliency against economic and financial framework, though regulators have allowed a shocks. The Council recommends that regulators delayed capital phase-in to reduce the burden continue to monitor the capital adequacy for during the pandemic. these banks and, when appropriate, phase out the temporary capital relief currently provided. The credit line withdrawals and the increase in loan loss provisions have put downward pressure on both The Council also recommends that regulators leverage and risk-based capital ratios. As credit and continue to monitor and assess the impact of rules equity markets rebounded from their March lows, on financial institutions and financial markets— broker-dealers and trust banks have also benefited including, for example, on market liquidity and from significant increases in trading revenues and capital—and ensure that BHCs are appropriately underwriting income. However, for banks with monitored based on their size, risk, concentration larger credit footprints, the impending declines in of activities, and offerings of new products and credit quality have led to voluntary and involuntary services. restrictions on their capital distributions. The Council further recommends that the In light of the financial fallout from the COVID-19 appropriate regulatory agencies continue to review pandemic, regulatory authorities have provided resolution plans submitted by large financial temporary capital relief as many large banks institutions; provide feedback and guidance to voluntarily suspended share repurchases in mid- such institutions; and ensure there is an effective March. Following the release of the 2020 stress test mechanism for resolving large, complex institutions. results conducted by the Federal Reserve, large banks are required to preserve capital by suspending 5.3.2 Investment Funds stock repurchases, capping dividend payments, and Investment funds play a critical intermediary limiting dividends according to a formula tied to role in the U.S. economy, promoting economic recent income. In spite of these policy measures, growth through efficient capital formation. While the largest banks remain vulnerable to a protracted recognizing these benefits, the Council has also downturn that is more severe than currently identified a potential vulnerability relating to envisaged. These outcomes have been discussed redemption risk in certain open-end funds. The under the 2020 Stress Test Results conducted by level of this risk is a function of, among other the Federal Reserve in their Assessment of Bank things, the liquidity of the underlying assets, the Capital during the Recent Coronavirus Event (see Chart effectiveness of the fund’s management of its 3.5.1.27). liquidity, and the potential for an investor to enjoy a first-mover advantage. For example, although Recommendations both equity and fixed income-oriented open-end Large and complex U.S. financial institutions were funds offer daily redemptions to investors, some more resilient prior to the pandemic than they were fixed-income markets are less liquid than equity prior to the 2008 financial crisis. This resilience markets and thus funds holding mostly fixed-income has been achieved, in part, by raising more capital; instruments may face greater vulnerability to run holding higher levels of liquid assets to meet peak risks than funds holding mostly equities. During demands for funding withdrawals; improving periods of significant financial stress, as investor loan portfolio quality for residential real estate; sentiment about overall economic and market implementing better risk management practices; conditions changes, these funds – not unlike other
174 2020 FSOC // Annual Report investors such as insurance companies, pension Recommendations funds, and individual investors – may be inclined The Council supports initiatives by the SEC and to directly sell these fixed-income instruments for other agencies to address risks in investment funds. cash. The Council has focused in particular on the The Council also supports data collection and question of whether the structure of open-end funds analytical work by member agencies aimed at the results in greater selling pressure than if investors identification of potential emerging risks. The SEC held the fixed-income instruments directly. The implemented several data collection efforts and SEC has taken several steps to address this potential has established additional reporting requirements vulnerability, including the adoption in October for investment funds. As a result, there is now 2016 of rules intended to enhance liquidity risk significantly more data available to regulators to management by mutual funds and ETFs. monitor and analyze developments concerning fund liquidity, leverage, and risk-taking. The Council During the mid-March financial turmoil, credit recommends that the SEC and other relevant spreads increased to levels not seen since the 2008 regulators consider whether there are additional financial crisis, and corporate bond issuance came steps that should be taken to address these to a near halt. As discussed in Section 3.5.2.4, vulnerabilities. bond funds experienced historically high levels of outflows that some research has suggested 5.4 Financial Market Structure, Operational contributed to stress in corporate and municipal Challenges, and Financial Innovation bond markets. Interventions by the Federal Reserve and Treasury, including a commitment to purchase 5.4.1 Central Counterparties up to $250 billion of bonds, ultimately restored The benefits of CCPs include improved orderly functioning in the primary and secondary transparency, the application of centralized markets. Nonetheless, these events demonstrate the risk management and standardized margin need for additional analysis to assess broader market methodologies, multilateral netting, and clear, structure dynamics that may have contributed to the predetermined procedures for the orderly stress, including whether investors redeeming shares management of counterparty credit losses. Central from bond funds may have affected the extent of clearing mandates have increased the volume of selling pressure in the bond market differently than cleared OTC derivatives trades, both in absolute if those investors had held and sold bonds directly. terms and relative to the size of the markets.
In addition to the potential vulnerability associated The introduction of the CPMI-IOSCO Principles with redemption risk in mutual funds, the Council for Financial Market Infrastructures (PFMI) sets has also previously highlighted the use of leverage forth international principles for CCPs and other by investment funds. The use of leverage is types of financial market infrastructures. The most widespread among hedge funds but varies implementation of the PFMI worldwide, as well significantly among hedge funds of different sizes as other risk-management-focused policies, has and investment strategies (see Section 3.5.2.5). improved the safety and efficiency of CCPs across a Leverage can allow investment funds to hedge risk broad set of jurisdictions. or increase exposures, depending on the activities and strategies of the fund. However, leverage There have also been advances in the development introduces counterparty risk, and in a period of of plans for CCP recovery. Regarding those CCPs stress, if leveraged investment funds are forced to designated as systemically important FMUs by the sell assets on a significant scale, it could exacerbate Council, the CFTC has regulations requiring such asset price movements. As discussed in Box B, hedge CCPs it supervises to maintain recovery and orderly funds may have also contributed to Treasury market wind-down plans, and the CFTC has reviewed and volatility. provided guidance on these recovery plans. The SEC has also approved recovery and orderly wind-down plans for the CCPs it supervises.
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 175 Although CCPs provide significant benefits to and SEC maintain active risk surveillance programs market functioning and financial stability, the of CCPs’ and intermediaries’ risk management and inability of a CCP to meet its obligations arising receive daily or weekly reports of positions, risk from one or more clearing member defaults could measures, margins, collateral, and default resources. potentially introduce strains on the surviving members of the CCP and, more broadly, the In addition to risk surveillance programs, financial system. The overall market impact of supervisory stress tests involving multiple CCPs can these demands depends on the size of the CCP be an important tool in this assessment. Supervisory and its interconnectedness with other systemically stress tests can, for example, help shed light on important financial institutions. the risks and vulnerabilities related to potential failures of the largest clearing members. Because CCPs’ risk management frameworks are designed these clearing members are often active across many to ensure that they have sufficient pre-funded markets, such failures could create exposures across resources to cover a member default and, in the multiple CCPs. case of systemically important CCPs, multiple member defaults. In order to mitigate their risk, Recommendations CCPs impose liquidity and resource requirements The Council recommends that the CFTC, Federal on clearing members that can increase with market Reserve, and SEC continue to coordinate in the volatility. The first line of defense of the CCP is often supervision of all CCPs designated by the Council through initial margin requirements which, in order as systemically important FMUs. Relevant agencies to achieve adequate risk coverage, are inherently should continue to evaluate whether existing procyclical. Initial margin models, however, also risk management expectations for CCPs are have features that mitigate procyclicality, including sufficiently robust to mitigate potential threats the use of historical and theoretical stress scenarios to financial stability. Member agencies should even during low volatility periods, to dampen the continue working with global counterparts and sensitivity of initial margin to changes in market international standard-setting bodies to identify volatility. and address areas of common concern. During the last year, EU authorities and the CFTC have taken In response to the market volatility in March 2020, a number of steps to provide greater clarity to the aggregate margin levels increased significantly. regulation and supervision of CCPs operating in However, the markets served by the CCPs continued their markets. The Council encourages continued to function in an orderly fashion (see Section engagement by Treasury, CFTC, Federal Reserve, 3.6.1.1). While the cleared derivatives markets and SEC with foreign counterparts to address the functioned as designed, there is continued concern potential for inconsistent regulatory requirements about the impact on clearing members and their or supervision to pose risks to U.S. financial stability clients of liquidity demands related to margin and encourages cooperation in the oversight and requirements. Similar concerns exist in the context regulation of FMUs across jurisdictions. of uncleared swaps and the collateral flows between swap dealers and their clients. Relevant authorities The Council also encourages agencies to continue are engaged in efforts to examine the performance to monitor and assess interconnections among of CCPs’ and dealers’ margin frameworks and the CCPs, their clearing members, and other financial potential strains placed on intermediaries and institutions. While margin requirements have clients. increased significantly in the aftermath of the financial fallout from the COVID-19 pandemic, A number of regulatory efforts have focused on agencies should continue to analyze and monitor the monitoring and quantifying potential systemic risks. impact of regulatory risk management frameworks Many authorities regularly monitor risk exposures in cleared, uncleared, and related securities at CCPs and clearing members or broker-dealers markets and their impact on systemically important pursuant to their regulatory regime. Both the CFTC intermediaries and clients.
176 2020 FSOC // Annual Report Finally, the Council encourages regulators to been faster in derivatives cleared on CCP platforms continue to advance recovery and resolution and floating-rate note (FRNs) markets, and relatively planning for systemically important FMUs and to slower in bilateral markets with bespoke contract coordinate in designing and executing supervisory terms, such as bank loans to businesses (see Section stress tests of multiple systemically important CCPs. 3.5.3.2). Despite this progress, market participants with significant exposure to USD LIBOR remain 5.4.2 Alternative Reference Rates vulnerable if they do not sufficiently prepare prior The UK FCA continues to urge firms and regulators to the end of 2021. to prepare for a transition away from LIBOR on a global scale by year-end 2021. With more than $200 Legacy cash products and new transactions without trillion of USD LIBOR-based contracts outstanding, robust fallback language present a particular the transition from LIBOR, given its anticipated difficulty for transition. Contractual fallback cessation or degradation, will require significant provisions may not contemplate the need for an effort from market participants. The failure of alternative rate or may include provisions that market participants to adequately analyze their probably cannot be operationalized in the event exposure to LIBOR and transition ahead of LIBOR’s of LIBOR’s cessation, like the polling of LIBOR anticipated cessation or degradation could expose panel banks by the issuer. While many new FRN market participants to significant legal, operational, issuances include more robust contract fallback and economic risks that could adversely impact U.S. language, some new issuances still do not include financial markets. these provisions, putting issuers and investors at risk. Securitized products are further complicated, In March, the FCA stated publicly that, despite the as legacy contracts may require the consent of all COVID-19 pandemic, the assumption that firms parties to amend the transaction and new issuance cannot rely on LIBOR being published after the continues to use legacy language that may not end of 2021 has not changed (see Section 3.6.1.2). be feasible to implement. Re-documenting these Currently, the FCA has voluntary agreements with products will require significant effort and expense, LIBOR panel banks to continue submissions for and in most cases, it may not be possible to contact publication of LIBOR through year-end 2021. and obtain the required consent from all parties The FCA expects some banks to stop submissions involved; the slow adoption of more robust fallback around that time. If a bank leaves the LIBOR language in these instruments, therefore, presents a submission panel, the FCA must assess whether particular vulnerability. LIBOR continues to be representative of the underlying market. The FCA could deem LIBOR Consumer exposures to LIBOR, most commonly “unrepresentative,” at which time EU-regulated through adjustable-rate mortgages, present a special financial institutions would no longer be able to set of considerations in addition to those discussed. rely on the rate for new transactions. Additionally, Noteholders will need to take care in working to if enough banks leave the LIBOR panel, LIBOR ensure that consumers are treated fairly and that the may cease to be published. Even if LIBOR continues transition is explained clearly. The ARRC is working for some period with diminished submissions, with consumer groups, lenders, investors, and its performance may become increasingly regulators to achieve a smooth LIBOR transition. unpredictable and unstable. Recommendations In the U.S., the ARRC has made significant progress The ARRC has released the Recommended Best toward analyzing and adopting an alternative Practices for completing the transition from LIBOR. rate (SOFR), creating robust contract fallback Market participants should analyze their exposure to language for a variety of products, and building USD LIBOR, assess the impact of LIBOR’s cessation the infrastructure for the development of SOFR or degradation on existing contracts, and remediate markets. Broadly speaking, the pandemic has not risk from existing contracts that do not have robust materially slowed the progress, but progress has fallback arrangements to transition the contract
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 177 to an alternate rate. Market participants should 5.4.3 Financial Market Structure consider participation in ISDA’s protocol, which The extreme volatility in financial markets early in takes effect in 2021, as it will be especially important the pandemic further emphasized the importance in remediating risks to existing derivatives contracts of ensuring that appropriate market structures referencing LIBOR. Market participants that are in place so that financial markets can function do not sufficiently prepare for this inevitable effectively during stress events. Advances in transition could face significant legal, operational, information and communications technologies, as and economic risks. Market participants that have well as regulatory developments, have altered the determined that SOFR is an appropriate rate for structure of financial markets over the last decade. their LIBOR transition should not wait for the The Council and member agencies are closely possible introduction of the forward-looking SOFR monitoring how changes in market structure have term rates to execute the transition. The Council affected the robustness and efficiency of capital recommends that market participants formulate markets and the stability of the financial system. and execute transition plans so that they are fully prepared for the anticipated discontinuation or Interlinkages among dollar funding markets: degradation of LIBOR. Because of the uncertainty In the decade since the 2008 financial crisis, around the exact timing of the cessation of LIBOR, new regulations on bank capital and liquidity, including the potential of LIBOR to be deemed non- structural reforms in MMFs, and a new operating representative by the FCA under UK regulations, environment for bank-affiliated broker dealers have market participants should formulate and execute fundamentally altered how market participants plans to transition prior to year-end 2021, taking interact and the various interlinkages among the into account their business requirements. Market federal funds market, the repo market, and the participants must understand the exposure of their Eurodollar market. firm to LIBOR in every business and function, assess the impact of LIBOR’s cessation or degradation Some market participants are active in both secured on existing contracts, and remediate risks from and unsecured short-term funding markets. existing contracts that do not have robust fallback Commercial banks, affiliated broker dealers, and provisions to transition the contract to an alternate the FHLBs operate in the secured repo market as rate. It is also important that participants consider well as the unsecured federal funds market. While potential LIBOR exposure in services provided by money funds lend in the repo and the Eurodollar third parties, such as contract servicing, systems, market, they cannot participate in the federal funds and models. Market participants should evaluate market. Meanwhile, borrowing options in the dollar whether any new agreements contain sufficiently funding market for some entities, such as hedge robust fallback provisions, such as those endorsed funds, are limited to the repo market. Given the by the ARRC, to mitigate risk that the contract’s myriad of participants and strong interlinkages interest rate benchmark becomes unavailable. between them, disruptions in one market can transmit to another (see, for example, Box D). The Council commends the efforts of the ARRC and recommends that it continue to facilitate an orderly There are benefits from interdependencies among transition to alternative reference rates. Council markets, including enhanced price discovery and member agencies should determine whether more options for hedging risks. At the same time, further guidance or regulatory relief is required to interdependencies create transmission risks from encourage market participants to address legacy volatile or inaccurate pricing that have the potential LIBOR portfolios. Council member agencies should to amplify market shocks across different markets. also use their supervisory authority to understand the status of regulated entities’ transition from Pressures on dealer intermediation: The financial LIBOR, including their legacy LIBOR exposure and fallout from the pandemic was disruptive in the plans to address that exposure. markets for critical securities such as Treasuries (see Box B), MBS (see Section 3.3.5), and corporate
178 2020 FSOC // Annual Report bonds (see Box A). Market disruptions not only have market. For example, the volatility experienced implications for financial stability but also affect the in September 2019 and March 2020 has renewed implementation of monetary policy. attention on the dealers’ traditional role of direct liquidity provision through market-making. To Traditionally, market-making and arbitrage the extent that dealers have reduced their market mechanisms involving securities dealers have helped footprint over time, this could contribute to in the orderly functioning of the secondary market market volatility, particularly during stress events. for Treasury and MBS. Bank-affiliated broker- The significant role of non-traditional market dealers are also the principal participants in the participants may have also amplified market tri-party and GCF repo markets that use these volatility. The temporary solution has been to securities as collateral. provide more balance sheet space to BHCs in the form of relief on capital and liquidity regulation so However, two developments in the post-crisis that affiliates of the BHCs are better positioned to financial landscape have imposed significant intermediate investors’ demands for liquidity. In pressures on dealer intermediation. First, issuance addition, the Federal Reserve has increased the size volumes of these marketable securities, especially of its balance sheet to absorb selling pressures on Treasury securities, have increased significantly. Treasury and MBS to a significant degree. Second, the post-crisis regulatory framework has also imposed balance sheet constraints at bank- In light of these developments, there should be affiliated broker-dealers. With the implementation active collaboration among regulators across of Basel III regulations on capital and leverage, jurisdictions to ensure coordination of efforts. major bank-affiliated broker-dealers have reduced The Council recommends that member agencies the amount of their balance sheet that is allocated conduct an interagency operational review of to trading and repo transactions. Together, these market structure issues that may contribute to developments may have contributed to episodes of market volatility in key markets, including short- illiquidity in Treasury, MBS, and corporate bond term funding, Treasuries, MBS, and corporate bond markets in March 2020 (see Box B and Section markets, and study the interlinkages between them. 3.4.2.2). Market participants should also regularly assess how market developments affect the risk profile of their Role of non-traditional market participants: Non- institutions. The Council recommends that financial traditional market participants, including principal regulators continue to monitor and evaluate trading firms, play an increasingly important role ongoing changes that might have adverse effects on in securities and other markets. These firms may markets, including on market integrity and liquidity. improve liquidity and investor outcomes under normal circumstances, but they may also introduce 5.4.4 Cybersecurity new potential risks. For instance, the trading Financial institutions continue to invest in and strategies that non-traditional market participants expand their reliance on information technology employ and the incentives and constraints that and cloud-based computing to reduce costs and to they operate under may not be as well understood, increase efficiency and resiliency. The COVID-19 leading to uncertainty about how these firms might pandemic may accelerate this trend as financial behave during periods of market stress. institutions have implemented business continuity plans through increased use of teleworking systems Recommendations and dual work locations, for example. However, Episodes of volatility in wholesale funding greater reliance on technology, particularly across a markets over the past two years have highlighted broader array of interconnected platforms, increases the importance of interdependencies across the the risk that a cybersecurity incident may have different dollar funding markets. Policy measures severe consequences for financial institutions. In to address imbalances in one funding market can fact, a recent analysis by economists at the FRBNY potentially create imbalances in another funding details how impairment of payment systems at any
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 179 of the five most active U.S. banks would result in The incident could compromise the integrity of significant spillovers to other banks. critical data. Accurate and usable information is critical to the stable functioning of financial The financial sector, like other critical sectors, is firms and the system; if such data is corrupted vulnerable to malware attacks, ransomware attacks, on a sufficiently large scale, it could disrupt the denial of service attacks, data breaches, and other functioning of the system. The loss of such data also events. Such incidents have the potential to impact has privacy implications for consumers and could tens or even hundreds of millions of Americans and lead to identity theft and fraud. result in financial losses of billions of dollars due to disruption of operations, theft, and recovery costs. Recommendations Improving the cybersecurity and operational The implementation of teleworking strategies resilience of the financial sector requires continuous using virtual private networks, virtual conferencing assessment of cyber vulnerabilities and critical services, and other technologies can increase connections across firms. Sustained senior-level cybersecurity vulnerabilities, insider risks, and other commitment to mitigate cybersecurity risks and operational exposures (see Section 3.6.2). Market their potential systemic implications is necessary at participants have observed a spike in COVID-19 both member agencies and private firms. related phishing attacks, as attackers seek to exploit less secure home networks. At the same time, The Council recommends that federal and state financial institutions have increased their reliance agencies continue to monitor cybersecurity risks on third-party service providers for teleworking tools and conduct cybersecurity examinations of financial and services. The interdependency of these networks institutions and financial infrastructures to ensure, and technologies supporting critical operations among other things, robust and comprehensive magnifies cyber risks, threatening the operational cybersecurity monitoring, especially in light risk capabilities not just at individual institutions, of new risks posed by the pandemic. However, but also of the financial sector as a whole. the authority to supervise third-party service providers varies across financial regulators. To A destabilizing cybersecurity incident could further enhance third-party service provider potentially threaten the stability of the U.S. financial information security, the Council recommends system through at least three channels: that Congress pass legislation that ensures that FHFA, NCUA, and other relevant agencies have The incident could disrupt a key financial service or adequate examination and enforcement powers to utility for which there is little or no substitute. This oversee third-party service providers. The Council could include attacks on central banks; exchanges; also recommends that federal banking regulators sovereign and sub-sovereign creditors, including continue to coordinate third-party service provider U.S. state and local governments; custodian banks, examinations, work collaboratively with states, payment clearing and settlement systems; or other and also work with the State Liaison Committee firms or services that lack substitutes or are sole to identify additional ways to support information service providers. sharing among state and federal regulators.
The incident could cause a loss of confidence among The Council encourages continued cooperation a broad set of customers or market participants. If across government agencies and private firms it causes customers or participants to question the to improve cybersecurity through the adoption safety of their assets or transactions and leads to of authenticable digital identities that offer significant withdrawal of assets or activity, the effects agencies and firms the ability to mitigate the could be destabilizing to the broader financial risk of cybersecurity incidents through digital system. authentication of parties (e.g. trading partners, vendors, customers) to enhance the financial sector’s strong cybersecurity posture.
180 2020 FSOC // Annual Report The Council supports the ongoing work of emerging technologies change the sector’s risk partnerships between government agencies and profile, and consider the need for any corresponding private firms, including the Financial and Banking change to supervision and regulation. Information Infrastructure Committee (FBIIC), the Financial Services Sector Coordinating Council, 5.4.5 Data Gaps and Challenges and the Financial Services Information Sharing The 2008 financial crisis exposed several major and Analysis Center (FS-ISAC). These partnerships gaps and deficiencies in the range and quality of focus on improving the financial sector’s ability data available to financial regulators to identify to rapidly respond to and recover from significant emerging risks in the financial system. These gaps cybersecurity incidents, thereby reducing the and shortcomings include firm-level structure and potential for such incidents to threaten the stability ownership information; transaction data in certain of the financial system and the broader economy. important financial markets, including short-term funding, securities lending arrangements, repo The Council recommends that the FBIIC continue contracts, and OTC derivatives; and limitations to promote processes to strengthen response and in financial statement reporting for certain types recovery efforts, including efforts to address the of institutions. The usefulness of data was often systemic implications of significant cybersecurity limited by institutional or jurisdictional differences incidents. The FBIIC should continue to work in reporting requirements. These types of closely with the Department of Homeland Security, inconsistencies created challenges for data sharing law enforcement, and industry partners to carry and increased the reporting burden on market out regular cybersecurity exercises recognizing participants. interdependencies with other sectors, such as telecommunications and energy. Progress has been made on these fronts. Reporting of centrally cleared repurchase rate agreements The Council further recommends that agencies initiated by the OFR in 2019 incorporates the use work to improve information sharing among of the LEI. Trade Information Warehouse data on private firms and government partners. Sharing credit derivatives provided to OFR is currently being timely and actionable cybersecurity information revised to also include the LEI. can reduce the risk that cybersecurity incidents occur and can mitigate the impacts of those that Council member agencies have been actively do occur. Treasury and relevant agencies should engaged with each other, regulators in other carefully consider how to appropriately share jurisdictions, and firms in the financial sector to information and, where possible, continue efforts develop standards and protocols and to execute on to declassify (or downgrade classification) to the data collection initiatives. Staff of the OFR, CFTC, extent practicable, consistent with national security SEC, and Federal Reserve meet regularly with their imperatives. The Council encourages efforts to international regulatory counterparts from the enhance information sharing with the FS-ISAC FSB to implement UTIs, UPIs, and CDE standards and its growing community of financial sector for OTC derivatives and have recently developed institutions. a governance structure for oversight. Member agencies have also been working to facilitate the Financial institutions are rapidly adopting new adoption of LEIs and Universal Loan Identifiers technologies, including cloud computing and (ULIs) for mortgage loans. artificial intelligence. The Council supports the efforts of the FBIIC Technology Working Group, Recommendations which examines the extent to which financial High-quality financial data is an essential input services firms using emerging technologies into the financial regulatory process. The Council introduce new cyber vulnerabilities into the and member agencies rely on data collected from financial services critical infrastructure. The market participants to monitor developments in the Council recommends agencies consider how such financial system, identify potential risks to financial
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 181 stability, and prioritize and execute supervisory derivatives data for aggregation and reporting and and examination work. The Council encourages ensure that appropriate authorities have access member agencies to collaborate and expand their to trade repository data needed to fulfill their data resources and analytical capabilities to assess mandates. interconnectedness and concentration risks in their respective areas of responsibility. The Council encourages pension regulators and FASB to improve the quality, timeliness, and depth The establishment of uniform standards for of disclosures of pension financial statements. reporting and collection enhances the usefulness of market data and reduces the reporting 5.4.6 Financial Innovation burdens on market participants. The failure to Financial innovation offers considerable benefits adopt broadly shared granular data standards to consumers and providers of financial services for financial products, transactions, and entities by reducing the cost of certain financial services, can lead to unnecessary costs and inefficiencies, increasing the convenience of payments, and such as duplicate reporting, and may impede the potentially increasing the availability of credit. But ability to aggregate data for risk-management and innovation can also create new risks that need to be reporting purposes. The Council recommends understood. that regulators and market participants continue to partner to improve the scope, quality, and Digital assets, which are still a new and relatively accessibility of financial data, as well as data sharing small sector of the financial market, are a among relevant agencies. These partnership efforts particularly good example of both the benefits and include implementing new identifiers such as the potential risks associated with innovation. Digital UTI, Unique Product Identifier (UPI), and CDE; assets may present a new means of conducting real- developing and linking data inventories; and time payment activities. Some nations have begun implementing industry standards, protocols, and exploring or, in some cases, using central bank security for secure data sharing. digital currencies to enhance the global standing of their own currencies and enable faster payments. Broader adoption of the LEI by financial market Likewise, several nations have begun assessing participants continues to be a Council priority. The whether and how privately-issued stablecoins may LEI enables unique and transparent identification of serve a role in facilitating faster and more efficient legal entities participating in financial transactions. payments, provided that such activities are subject to ULIs will make it possible to track loan records appropriate regulation and oversight. through a loan’s life cycle. The Council recommends that member agencies update their regulatory However, if a stablecoin became widely adopted as mortgage data collections to include LEI and ULI a means of payment or store of value, disruptions fields. The Council also recommends that member to the stablecoin system, as with any payment or agencies support adoption and use of standards value system, could affect the financial system and in mortgage data, including consistent terms, the wider economy, warranting greater regulatory definitions, and data quality controls, which will scrutiny. A decline in the value of assets involved in make transfers of loans or servicing rights less a traditional or new payment or value system can disruptive to borrowers and investors. result in the transmission of risk to the financial sector through financial institution exposures, risks Important initiatives are underway at member to the payment system involved, wealth effects and agencies that will improve the functioning of confidence effects. Risks to payment systems, if not financial markets. Among these is the collection of properly managed, can present financial stability repo transaction data, which is used to create SOFR risks, given the importance of a well-functioning benchmark rates for use by market participants. payments system in facilitating commercial activities. The Council recommends that member agencies continue to work to harmonize domestic and global
182 2020 FSOC // Annual Report The benefits and potential risks associated with and services; in evaluating how innovation is used; digital assets underscore the importance of U.S. and in monitoring how responsible innovation can regulators adopting an approach to digital assets that benefit investors and consumers, regulated entities, will provide for responsible innovation in a manner and financial markets. The Council also encourages that is safe, fair, and complies with all applicable laws. relevant authorities to evaluate the potential effects Clear guidance will support the development of a of new financial products and services on financial payment system that is consistent with the changing stability, including operational risk. Agencies should needs of institutions and consumers within the U.S. ensure that their monitoring and data collection and that is competitive with payment systems abroad. systems identify risks associated with financial This is particularly important given the European innovations. To ensure comprehensive visibility into Commission’s recently revealed draft framework for innovation across the financial system and avoid cryptoassets and stablecoins. regulatory fragmentation, regulators should share relevant information on financial innovation as The continued evolution of the market for digital appropriate with the Council and other agencies. assets highlights the importance of coordinated engagement and leadership by relevant U.S. The Council recommends that federal and state regulators. Digital asset arrangements vary widely regulators continue to support responsible innovation (see Section 3.6.3.1). The risk each digital asset by examining the benefits of, and potential risks to poses depends, among other things, on its overall the financial system posed by, new and emerging uses usage in the market, the structure of the asset and of digital assets and distributed ledger technologies. its consensus mechanism, and the risk management Financial regulators should review existing and practices of participants. The potential risks planned digital asset arrangements and their risks as presented by different stablecoin systems may vary appropriate. according to the mechanism by which they are made stable and the governance policies of the The Council encourages continued coordination administrator. among federal and state regulators to support responsible financial innovation and competitiveness, As discussed in Section 3.6.3.4, large technology promote consistent regulatory approaches, as well as and e-commerce companies providing financial to identify and address potential risks that arise from services may increasingly seek to compete directly such innovation. with incumbent financial service providers, and their market presence could grow significantly. These firms currently may not be subject to the same type of financial services regulation with which incumbent financial service providers are required to comply.
Financial firms’ rapid adoption of fintech innovations in recent years may increase operational risks associated with financial institutions’ use of third- party service providers. Third-party service providers may create financial stability risks if financial institutions outsource critical services because operational failures or faults at a key service provider could disrupt the activities of multiple financial institutions or financial markets.
Recommendations The Council encourages financial regulators to continue to be proactive in identifying new products
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 183 5.5 Global Economic and Financial September 28, 2020, the European Securities and Developments Markets Authority granted time-limited equivalence to three UK CCPs, which allows them to continue Downside risks to global economic growth have providing their services in the EU until mid-2022. increased significantly since the outbreak of While this development has reduced financial the COVID-19 pandemic. In response to the stability risks, risks remain elevated as other UK collapse of global economic activity in the first financial services will lose passporting rights under half of 2020, national authorities in advanced and MiFD II at the end of the transition period absent many emerging economies implemented rapid any agreement. Additionally, the failure of the two and decisive fiscal and monetary policy actions. parties to reach a trade agreement at the end of the Although these measures helped support incomes transition period poses significant downside risks to and employment and eased global financial both the UK and the EU because of the disruptions conditions in the initial phase of the pandemic, the it would cause to cross-border supply chains. A path of the economic recovery will be dependent on no-trade-deal Brexit could lead to financial market continued fiscal and monetary support along with stress through several channels – disruptions in health policy responses, including authorities’ ability cross-border trade, reductions in investor confidence to limit the spread of COVID-19 without re-imposing in the UK economy, increased FX volatility, and a lockdown measures along with the development of decline in UK asset values. therapeutics and a vaccine. The size of the Chinese economy and its centrality At the onset of the pandemic, many European to global supply chains also makes it a potential countries introduced lockdowns to reduce the source of risk. After a rapid increase in debt and spread of the disease. These lockdowns led to a leverage following the 2008 financial crisis, Chinese sharp contraction in real activity and employment authorities began taking steps to encourage that could lead to significant losses in the banking financial deleveraging in 2016. In 2020, Chinese system. As part of their response to the crisis, regulators paused the deleveraging campaign as European governments undertook fiscal policy authorities try to balance COVID-19 related credit actions that increased government spending and support with longer-term financial stability goals tax relief and likely reduced financial stability risks (see Section 3.7.3). More significantly, the PBOC (see Section 3.7.2). Over the longer run, however, provided guidance to banks that they should additional expansionary policies may result in sizable sacrifice profits to help stabilize growth. Although increases in government debt and a further increase this guidance is likely to stabilize the Chinese in sovereign risk. If debt sustainability were to worsen economy in the short run, it comes at the expense in the highly indebted countries, it could stress of leaving the banking sector weaker and less likely European financial institutions and lead to political to rebuild capital margins over the medium run. tensions within the euro area. This distress has the At present, U.S. exposures to the Chinese financial potential to spill over to the U.S. financial system sector are limited, and financial stability risks through direct exposures and counterparty risks. associated with a potential decline in Chinese asset valuations or stress in the Chinese banking sector Although somewhat overshadowed by the COVID-19 appear manageable. Indirect effects on global crisis, the prospect of a no-trade-deal Brexit economic and market confidence, however, could represents an ongoing risk to both the European adversely impact U.S. economic performance. and U.S. financial systems. On January 31, 2020, the United Kingdom left the EU but remains under EU Similarly, EMEs represent another indirect source trade rules through the transition period, which of risk to the U.S. financial system. The COVID-19 is set to expire at the end of 2020 (see Section shock affected EMEs initially through a reduction 3.7.2). Regulators in Europe and the United States in Chinese demand and later through the spread of have taken steps to lessen potential disruptions the virus globally. In response, many EME central to the financial system of a disorderly Brexit. On banks broke with their usual policy of raising rates
184 2020 FSOC // Annual Report in the face of currency depreciation and massive portfolio outflows. Instead, they addressed the market stress by easing monetary policy, with many implementing bond purchase programs. Since the initial period of volatility and massive portfolio outflows in March and April, flows to EMEs have broadly stabilized, with risks to the external sector remaining moderate because many EMEs have relatively large foreign reserves. The current risks EMEs pose to the U.S. financial system are related to the build-up of sovereign and nonfinancial debt. The accumulation of sovereign debt creates the risk that it is not sustainable over the long run and that the necessary fiscal space will be unavailable to deal with additional contingencies, such as a renewed wave of COVID-19 infections. The rise in nonfinancial debt levels creates vulnerabilities because of a reduced repayment capacity during the recession. Although the direct exposures of the U.S. financial system to EMEs are limited, spillovers to the U.S. economy could manifest themselves in the form of shifts in market confidence or increases in market stress that lead to a tightening of U.S. financial conditions.
Potential Emerging Threats, Vulnerabilities, and Council Recommendations 185 Box G: “Low-For-Long” Interest Rates and Implications for Financial Stability
The Federal Reserve’s initial policy response to behavior may lead to the build-up of risks, are likely to the COVID-19 pandemic and later shift to average- vary across market participants. inflation targeting both imply that monetary policy will be accommodative for the foreseeable future. Retail investors Although a looser monetary policy stance is One of the main effects on retail investors of warranted by the need for immediate support to the persistently low rates is a decrease in their interest real economy and the achievement of the Federal income. As a result, retirees and other fixed-income Reserve’s maximum employment mandate, it also dependent investors may face a decline in their raises questions about the medium-term financial primary source of income, which, in principle, stability implications of long periods of low short- incentivizes them to reallocate their portfolio to riskier term rates and a potentially flatter yield curve. For assets, as it does for other market participants. But example, there is an inherent tradeoff between the predicting the precise effect of how retail investors evident need for low rates to stimulate economic respond is difficult because their balance sheets activity now and the possibility that persistently are smaller and their portfolios less diversified than low rates may distort risk-taking over a longer time institutions, and hence their behavior is more sensitive horizon. Understanding how such a “low-for-long” to risk. Empirical studies show that household environment reshapes market participants’ and savings are positively related to interest rates, though financial institutions’ incentives to borrow, lend, and the size of the effect varies widely. In addition, there take excessive risk is critical for understanding its is little systematic evidence on how low rates for financial stability implications. a prolonged period affect the portfolio allocation To that end, recent historical experience provides decisions of individual investors. Thus, while it is some guidance on the possible effects of a low- prudent to monitor possible reach-for-yield behavior for-long interest-rate environment. After the 2008 by retail investors, it is not clear that it has the same financial crisis, a combination of forces created broad financial stability implications that the decisions conditions under which interest rates were also of larger financial institutions do. expected to remain low for an extended period, Banks reducing yields on many assets and providing market Low interest rates are generally expected to reduce participants with the incentive to assume more banks’ profitability: Both low short-term rates and a financial risk – the so-called “reach for yield.” This flatter yield curve reduce banks’ interest income and reach-for-yield behavior led to increases in asset compress their net interest margin. How damaging prices in a range of markets, a portfolio reallocation to this deterioration in profitability will be remains an riskier and less liquid asset classes, and an increase open question. Banks are well capitalized today in corporate leverage. In today’s environment, it is as a result of the post-crisis financial reforms and possible that we will observe similar types of changes can draw on this capital buffer to absorb losses. in market participants’ behavior. Nevertheless, the resulting decline in banks’ profitability, in principle, gives them an incentive to Key Implications of Low-for-Long and Potential increase fees and other charges, make riskier loans, Vulnerabilities Low rates for an extended period will have broad and shift the composition of their balance sheets to implications for several key market participants. At the generate other sources of income. same time, the types of behavior low interest rates The evidence that banks’ behavior in a low-for-long will induce, and therefore the extent to which that environment leads to an increase in systemic risk is more mixed, however. A retrospective analysis of
186 2020 FSOC // Annual Report the post-financial crisis period conducted by financing because of lower credit spreads in the future. the Committee on the Global Financial System These easier financing conditions are likely to fuel the (CGFS) suggests that while low interest rates same trend in debt accumulation that pre-dated the and flatter yield curves reduce net interest current period of low interest rates, creating a potential margins, as expected, banks in the United vulnerability in the form of excessive corporate debt levels. States and elsewhere adjusted in ways that mitigated the effects on their overall return Pension funds on assets. What is more, the study found no Low interest rates also affect the demand for risky assets systematic correlation between the level of through their effect on pension funds and insurance interest rates, on the one hand, and measures companies, which face similar issues because of the of bank soundness and excessive risk-taking, structure of their balance sheets. Both types of institutions on the other. In terms of evidence for the United have long-lived liabilities that make them vulnerable to States specifically, research shows that while declining or low interest rates. For pension funds, low a low interest rate environment is generally rates increase the present value of their assets and associated with narrower net interest margins liabilities, but the duration of their liabilities is higher and reduced profitability, especially for small than that of their assets. As a result, the duration effect banks, these negative effects may be offset implies that low interest rates have a net negative effect by the positive effects of low rates on profits on their balance sheets. To meet their expected return through increased economic activity. Thus, while targets, pension funds can respond in several ways -- by net interest margins do narrow when interest increasing contribution requirements, by switching to rates are lower, the overall effects on profitability alternative investments such as private equity, by issuing and excessive risk-taking seem to be more pension obligation bonds to increase leverage, or by muted than might be expected, and the broader increasing the duration of their assets. These adjustments effects on systemic risk in the banking sector are likely to happen gradually because pension funds modest. have long liability maturities and are hence unlikely to pose an immediate risk to financial stability. Corporations The combined effect of low expected returns and state For corporations, low rates affect both their and local budget shortfalls also creates a set of risks borrowing behavior and the willingness of for public pensions. These two factors may force state investors to supply credit to them. Even before and local governments to make tradeoffs between we entered the current low-for-long environment, meeting their public pension liabilities, which have strong the level of corporate indebtedness was high legal protections, and current spending demands that by historical standards, driven, in part, by will stress public finances. Because most states have the growth in the leveraged loan market to balanced-budget requirements, these tradeoffs could be lower-rated borrowers. This growth was itself especially stark. The reconciliation of these underlying a consequence of a prolonged period of low tensions may manifest themselves in the municipal bond rates after the 2008 financial crisis. Today, low market if investors begin to question the long-term ability yields are encouraging borrowers to lock in rates of states and localities to meet their existing obligations. with fixed-rate corporate bonds, as opposed to leveraged loans, which are floating-rate Insurance companies instruments. As a result, high-yield corporate Insurance companies could face greater challenges bond issuance is at a record level in 2020. with their balance sheets. Low interest rates compress Moreover, firms that successfully weather the insurers’ investment margins, reduce their ability to meet current COVID crisis will have easier access to their product guarantees, and weaken their earnings
Box G: “Low-For-Long” Interest Rates and Implications for Financial Stability 187187 Box G: “Low-For-Long” Interest Rates and Implications for Financial Stability
and capital. For example, life insurance product in-the-future cash flow may have a disproportionate reserves are generally determined using a long-run effect on current valuations when interest rates are interest rate assumption in order to match assets and low. As a result, such rate changes can lead to sharp liabilities. However, life insurers’ net investment portfolio adjustments in valuations. The potential negative effects yields have been declining due to the reinvestment that an unexpected increase in rates would have across of maturing assets at lower rates. The industry’s net a variety of market participants make this longer-term investment portfolio yield has fallen from 6.0 percent risk worth monitoring. Adequate guidance on the timing in 2007 to 4.6 percent in 2019, and this trend can and pace of any such policy-related increase will likely be expected to continue. It provides an incentive to reduce this risk. increase allocations to riskier debt and less liquid assets to achieve the guaranteed returns on in force insurance policies. As in the case of pension funds, the challenges related to a protracted period of low interest rates confronting insurance companies manifest themselves over time, giving insurance companies some latitude in how they adapt to the low-rate environment. This flexibility reduces the likelihood of a broader financial disruption.
Longer-Term Risks Related to Future Rate Increases The discussion thus far has focused on current or medium-term implications of low-for-long. A longer- term risk is how the market participants’ exposures to greater levels of duration risk affect financial stability when rates eventually increase. The 2013 Taper Tantrum is an example of this potential dynamic, although the wider financial stability implications of that episode were limited. The potential risk here is that unexpected increases in rates negatively affect the balance sheets of financial institutions in such a way that leads to financial instability. Banks without adequate capital buffers could face solvency issues, while pension funds and insurance companies could experience liquidity problems related to losses on derivatives positions or increases in early liquidations. Additionally, with valuations in both equity and credit markets relatively high by historical standards and likely to become further stretched in a low-for-long environment, the risk of a sharp correction becomes more likely, especially in conjunction with high levels of leverage or excessive reliance on short-term wholesale funding. Even small changes to expectations of far-
188 2020 FSOC // Annual Report 6 Abbreviations
AANA Average Aggregate Notional Amount CMG Crisis Management Group ABS Asset-Backed Security Council Financial Stability Oversight Council ACL Allowances for Credit Losses CP Commercial Paper Advisers Investment Advisers Act of 1940 CPFF Commercial Paper Funding Facility Act CPI Consumer Price Index AML Anti-Money Laundering CPMI Committee on Payments and Market ANPR Advance Notice of Proposed Rulemaking Infrastructures APP Asset Purchase Programme CRA Community Reinvestment Act ARM Adjustable Rate Mortgage CRE Commercial Real Estate ARRC Alternative Reference Rates Committee CSBS Conference of State Bank Supervisors AUM Assets Under Management Desk Open Market Trading Desk BCBS Basel Committee on Banking Supervision DFAST Dodd-Frank Act Stress Tests BDC Business Development Company DIP Debtor-in-Possession BHC Bank Holding Company Dodd- Dodd-Frank Wall Street Reform and BIS Bank for International Settlements Frank Act Consumer Protection Act DSB Derivatives Service Bureau BOE Bank of England DSSI Debt Service Suspension Initiative BOJ Bank of Japan DTCC Depository Trust & Clearing Corporation BTP Italian Government Bond DTI Total Monthly Debt to Total Monthly Income Bund German Government Bond EBITDA Earnings Before Interest, Taxes, C&I Commercial and Industrial Depreciation, and Amortization CARES Coronavirus Aid, Relief, and Economic ECB European Central Bank Security EGRRCPA Economic Growth, Regulatory Relief, and CCAR Comprehensive Capital Analysis and Review Consumer Protection Act CCP Central Counterparty EME Emerging Market Economy CD Certificate of Deposit ENN Entity-Netted Notional CDB China Development Bank Enterprises Fannie Mae and Freddie Mac CDE Critical Data Elements ETF Exchange-Traded Fund CDO Collateralized Debt Obligation ETN Exchange-Traded Note CDS Credit Default Swap ETP Exchange-Traded Product CECL Current Expected Credit Losses EU European Union CEM Current Exposure Method Euro Stoxx 50 Euro Area Stock Index CET1 Common Equity Tier 1 Exchange Securities Exchange Act of 1934 CFPB Consumer Financial Protection Bureau Act CFT Countering the Financing of Terrorism Fannie Mae Federal National Mortgage Association CFTC Commodity Futures Trading Commission FASB Financial Accounting Standards Board CIF Collective Investment Funds FATF Financial Action Task Force CLO Collateralized Loan Obligation FBIIC Financial and Banking Information Infrastructure Committee CMBS Commercial Mortgage-Backed Security FBO Foreign Banking Organization CME Chicago Mercantile Exchange Inc. FCA Financial Conduct Authority
Abbreviations 189 FCM Futures Commission Merchant IAIS International Association of Insurance Supervisors FCU Federal Credit Union ICS International Capital Standard FDI Foreign direct investment IHC Intermediate Holding Company FDIC Federal Deposit Insurance Corporation IMF International Monetary Fund Federal Board of Governors of the Federal Reserve Reserve System Investment Investment Company Act of 1940 Company FHA Federal Housing Administration Act FHFA Federal Housing Finance Agency IPO Initial Public Offering FHLB Federal Home Loan Bank IOSCO International Organization of Securities FICC Fixed Income Clearing Corporation Commissions FICO Fair Isaac Corporation ISDA International Swaps and Derivatives Association FICU Federally Insured Credit Union ISO International Organization for FIMA Foreign and International Monetary Standardization Authority JGB Japanese Government Bond FinCEN Financial Crimes Enforcement Network LCR Liquidity Coverage Ratio FIO Federal Insurance Office LEI Legal Entity Identifier FMI Financial Market Infrastructure LEI ROC Legal Entity Identifier Regulatory Oversight FMU Financial Market Utility Committee FOMB Financial Oversight and Management Board M&A Merger and Acquisition FOMC Federal Open Market Committee MBS Mortgage-Backed Security FNAV Floating Net Asset MBSD Mortgage-Backed Securities Division FRBNY Federal Reserve Bank of New York MiFID II Markets in Financial Instruments Directive Freddie Federal Home Loan Mortgage Corporation MLF Municipal Liquidity Facility Mac MMLF Money Market Fund Liquidity Facility FRN Floating Rate Notes MMF Money Market Mutual Fund FSB Financial Stability Board mREIT Mortgage REITs FS-ISAC Financial Services Information Sharing and MSLP Main Street Lending Program Analysis Center FSOC Financial Stability Oversight Council MSP Major Swap Participant FX Foreign Exchange MSR Mortgage Servicing Right G-SIB Global Systemically Important Bank NAIC National Association of Insurance Commissioners GAAP Generally Accepted Accounting Principles NAL No-Action Letter GAV Gross Asset Value NAV Net Asset Value GCC Group Capital Calculation NCD Negotiable Certificates of Deposit GDP Gross Domestic Product NCUA National Credit Union Administration GLEIF Global LEI Foundation NIM Net Interest Margin GNMA Government National Mortgage Association NMDB National Mortgage Database (Ginnie Mae) GSE Government-Sponsored Enterprise NMS National Market System GSD Government Securities Division NPL Non-Performing Loan GUUG FSB’s Working Group on UTI and UPI NPRM Notice of Proposed Rulemaking Governance NSCC National Securities Clearing Corporation HFT High-Frequency Trader NYDFS New York Department of Financial Services HQLA High-Quality Liquid Asset OCC Office of the Comptroller of the Currency HMDA Home Mortgage Disclosure Act OFR Office of Financial Research
190 2020 FSOC // Annual Report OIS Overnight Index Swap SIPC Securities Investors Protection Corporation ON RRPF Overnight Reverse Repurchase Agreement SLOOS Senior Loan Officer Opinion Survey Facility SLR Supplementary Leverage Ratio OPEC Organization of Petroleum Exporting Countries SMBs Small and Mid-Sized Regional Banks OPEC+ OPEC and non-OPEC Participating Countries SMCCF Secondary Market Corporate Credit Facility OTC Over-the-Counter SME Small and Medium-Sized Enterprises P&C Property and Casualty SOFR Secured Overnight Financing Rate PBA Puerto Rico Public Buildings Authority SRC Systemic Risk Committee PBGC Pension Benefit Guaranty Corporation SPAC Special Purpose Acquisition Company PBOC People’s Bank of China STFM Short-Term Funding Market PDCF Primary Dealer Credit Facility STIF Short-Term Investment Fund PEPP Pandemic Emergency Purchase Programme SWIFT Society for Worldwide Interbank Financial PFMI Principles for Financial Market Telecommunications Infrastructures TALF Term Asset-Backed Securities Loan Facility PMCCF Primary Market Corporate Credit Facility TBA To Be Announced PPP Paycheck Protection Program TDR Troubled Debt Restructurings PPPLF Paycheck Protection Program Lending TIPS Treasury Inflation-Protected Securities Facility TLAC Total Loss Absorbing Capital PREPA Puerto Rico Electric Power Authority TLTRO Targeted Long-Term Refinancing Operations PROMESA Puerto Rico Oversight, Management, and Economic Stability Act Treasury Department of the Treasury PSPA Preferred Stock Purchase Agreement TRIA Terrorism Risk Insurance Act of 2002, as Amended PTF Principal Trading Firm TRIP Terrorism Risk Insurance Program QM Qualified Mortgage UK United Kingdom RBIC Rural Business Investment Companies ULI Universal Loan Identifier REIT Real Estate Investment Trust UMBS Uniform Mortgage-Backed Security Repo Repurchase Agreement UPB Unpaid Principal Balance RMB Renminbi UPI Unique Product Identifier RMBS Residential Mortgage-Backed Security USD U.S. Dollar ROAA Return on Average Assets USDA U.S. Department of Agriculture RRC Regulation and Resolution Committee RWA Risk-Weighted Asset UTI Unique Transaction Identifier S&P Standard & Poor’s VA U.S. Department of Veterans Affairs S&P LCD Standard & Poor’s Leveraged Commentary VaR Value at Risk & Data VRDN Variable-Rate Demand Notes SA-CCR Standardized Approach for Counterparty VIX Chicago Board Options Exchange Volatility Credit Risk Index SBA Small Business Administration WAL Weighted Average Life SBSD Security-Based Swap Dealer WAM Weighted-Average Maturity SD Swap Dealer WEO World Economic Outlook SDR Stressed Default Rate WLA Weekly Liquid Assets SEC Securities and Exchange Commission WTI West Texas Intermediate SEF Swap Execution Facility YTD Year-to-Date SIFMA Securities Industry and Financial Markets Association
Abbreviations 191
7 Glossary
Additional Tier 1 Capital Short-term debt which has a fixed maturity of up A regulatory capital measure that may include items to 270 days and is backed by some financial asset, such as noncumulative perpetual preferred stock such as trade receivables, consumer debt receivables, and mandatory convertible preferred securities securities, or auto and equipment loans or leases. that satisfy the eligibility criteria in the Revised Capital Rule, as well as related surplus and minority Asset-Backed Security (ABS) interests. A fixed-income or other type of security which is collateralized by self-liquidating financial assets that Advanced Approaches Capital Framework allows the holder of the security to receive payments The Advanced Approaches capital framework that depend primarily on cash flows from the assets. requires certain banking organizations to use an internal ratings-based approach and other Bilateral Repo methodologies to calculate risk-based capital A repo between two institutions in which requirements for credit risk and advanced negotiations are conducted directly between the measurement approaches to calculate risk-based participants or through a broker, and in which the capital requirements for operational risk. The participants must agree on the specific securities framework applies to large, internationally active to be used as collateral. The bilateral repo market banking organizations—generally those that includes both non-cleared trades and trades cleared are G-SIBs or with at least $700 billion in total through Fixed Income Clearing Corporation’s consolidated assets or at least $75 billion in cross- delivery versus payment repo service. jurisdictional activity with at least $250 billion in total consolidated assets or at least $10 billion Central Counterparty (CCP) in total on-balance sheet foreign exposure—and An entity which interposes itself between includes the depository institution subsidiaries of counterparties to contracts traded in one or more those firms. financial markets, becoming the buyer to every seller and the seller to every buyer, thereby ensuring the Affiliate performance of open contracts. In general, a company is an affiliate of another company if: (1) either company consolidates Clearing Bank the other on financial statements prepared A BHC subsidiary that facilitates payment and in accordance with U.S. Generally Accepted settlement of financial transactions, such as check Accounting Principles, the International Financial clearing, or facilitates trades between the sellers and Reporting Standards, or other similar standards; buyers of securities or other financial instruments or (2) both companies are consolidated with a third contracts. company on financial statements prepared in accordance with such principles or standards; (3) Collateral for a company that is not subject to such principles Any asset pledged by a borrower to guarantee or standards, consolidation as described above payment of a debt. would have occurred if such principles or standards had applied; or (4) a primary regulator determines Collateralized Loan Obligation (CLO) that either company provides significant support to, A securitization vehicle backed predominantly by or is materially subject to the risks or losses of, the commercial loans. other company. Asset-Backed Commercial Paper (ABCP)
Glossary 193 Commercial Mortgage-Backed Security (CMBS) Defined Benefit Plan A security which is collateralized by a pool of A retirement plan in which the cost to the employer commercial mortgage loans and makes payments is based on a predetermined formula to calculate derived from the interest and principal payments on the amount of a participant’s future benefit. In the underlying mortgage loans. defined benefit plans, the investment risk is borne by the plan sponsor. Commercial Paper (CP) Short-term (maturity of up to 270 days), unsecured Defined Contribution Plan corporate debt. A retirement plan in which the cost to the employer is limited to the specified annual contribution. In Commercial Paper Funding Facility (CPFF) defined contribution plans, the investment risk is A funding backstop established by the Federal borne by the plan participant. Reserve under section 13(3) of the Federal Reserve Act to facilitate the issuance of term commercial Digital Asset paper by eligible issuers. The CPFF is structured as a Digital asset is an asset that is issued/transferred credit facility to a special purpose vehicle. using distributed ledger or blockchain technology. A cryptocurrency is a digital asset designed to work Common Equity Tier 1 Capital (CET1) as a medium of exchange. Digital assets include A regulatory capital measure which includes capital instruments that may qualify under applicable U.S. with the highest loss-absorbing capacity, such as laws as securities, commodities, and security- or common stock and retained earnings. commodity-based instruments such as futures or swaps. Other industry terms used for these assets Common Equity Tier 1 Capital Ratio include cryptocurrencies, crypto assets, virtual A ratio which divides common equity tier 1 capital currencies, digital currencies, stablecoins, and by total risk-weighted assets. The ratio applies to all crypto tokens. banking organizations subject to the Revised Capital Rule. Dodd-Frank Act Stress Tests (DFAST) Annual stress tests required by the Dodd-Frank Act Comprehensive Capital Analysis and Review for national banks and federal savings associations (CCAR) with total consolidated assets of more than $10 An annual exercise by the Federal Reserve to ensure billion. that institutions have robust, forward-looking capital planning processes that account for their unique Duration risks and sufficient capital to continue operations The sensitivity of the prices of bonds and other throughout times of economic and financial stress. fixed-income securities to changes in the level of interest rates. Consumer Price Index (CPI) A monthly index containing data on changes in the Emerging Market Economy (EME) prices paid by urban consumers for a representative Although there is no single definition, emerging basket of goods and services. market economies are generally classified according to their state of economic development, liquidity, Credit Default Swap (CDS) and market accessibility. This report has grouped A financial contract in which one party agrees to economies based on the classifications used by make a payment to the other party in the event of a significant data sources such as the MSCI and specified credit event, in exchange for one or more Standard & Poor’s, which include, for example, fixed payments. Brazil, China, India, and Russia.
194 2020 FSOC // Annual Report Entity-Netted Notional (ENN) Markets following September 11, 2001 to improve A risk-based measure of size for the interest rate coordination and communication among financial swap market. To describe ENNs intuitively, imagine regulators, enhance the resiliency of the financial that each pair of swap counterparties established sector, and promote public-private partnership. its net interest rate risk position with bonds instead of swaps. More precisely, within each pair of Financial Market Infrastructure (FMI) counterparties, the counterparty that is net long has A multilateral system among participating financial purchased a 5‐year equivalent risk position in bonds institutions, including the operator of the system, from the counterparty that is net short. Then, the used for the purposes of recording, clearing, or sum of those hypothetical bond positions across all settling payments, securities, derivatives, or other pairs of counterparties is a measure of the size of the financial transactions. Under the Dodd-Frank Act, market and is equal to ENNs. certain FMIs are recognized as FMUs.
Exchange-Traded Product (ETP) Financial Market Utility (FMU) An investment fund or note that is traded on an An entity, as defined in the Dodd-Frank Act, that, exchange. ETPs offer continuous pricing—unlike subject to certain exclusions, “manages or operates a mutual funds, which offer only end-of-day pricing. multilateral system for the purpose of transferring, ETPs are often designed to track an index or a clearing, or settling payments, securities, or other portfolio of assets. ETPs include: (1) exchange- financial transactions among financial institutions traded funds (ETFs), which are registered as or between financial institutions and the person.” investment companies under the Investment Company Act of 1940 (’40 Act); (2) non-’40 Act Fire Sale pooled investment vehicles, which are generally The disorderly liquidation of assets to meet margin trust or partnership vehicles that do not invest in requirements or other urgent cash needs. Such securities; and (3) exchange-traded notes (ETNs), a sudden sell-off drives down prices, potentially which are senior debt instruments issued by below their intrinsic value, when the quantities to financial institutions that pay a return based on the be sold are large relative to the typical volume of performance of a “reference asset”. transactions. Fire sales can be self-reinforcing and lead to additional forced selling by some market Federal Funds Rate participants which, subsequent to an initial fire sale The interest rate at which depository institutions and consequent decline in asset prices, may also lend reserve balances to other depository need to meet margin or other urgent cash needs. institutions overnight. The FOMC sets a target range for the level of the overnight federal funds rate. The Fiscal Year Federal Reserve Bank of New York then uses open Any 12-month accounting period. The fiscal year for market operations to influence the rate so that it the federal government begins on October 1 and trades within the target range. ends on September 30 of the following year; it is named after the calendar year in which it ends. FICO Score A measure of a borrower’s creditworthiness based Futures Contract on the borrower’s credit data; developed by the Fair An agreement to purchase or sell a commodity Isaac Corporation. for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that Financial and Banking Information Infrastructure obligates each party to the contract to fulfill the Committee (FBIIC) contract at the specified price; (3) that is used The FBIIC consists of 18 member organizations to assume or shift price risk; and (4) that may be from across the financial regulatory community, satisfied by delivery or offset. both federal and state. It was chartered under the President’s Working Group on Financial
Glossary 195 General Collateral Finance (GCF) Initial Public Offering (IPO) An interdealer repo market in which the Fixed The first time a company offers its shares of capital Income Clearing Corporation plays the role of CCP. stock to the general public. Trades are netted at the end of each day and settled at the tri-party clearing bank. See Tri-party Repo. Institutional Leveraged Loan The term portion of a leveraged loan that is sold to Government-Sponsored Enterprise (GSE) institutional investors. A corporate entity with a federal charter authorized by law, but which is a privately owned financial Interest Rate Swap institution. Examples include the Federal National A derivative contract in which two parties swap Mortgage Association (Fannie Mae) and the Federal interest rate cash flows on a periodic basis, Home Loan Mortgage Corporation (Freddie Mac). referencing a specified notional amount for a fixed term. Typically, one party will pay a predetermined Gross Domestic Product (GDP) fixed rate while the other party will pay a short-term The broadest measure of aggregate economic variable reference rate which resets at specified activity, measuring the total value of all final goods intervals. and services produced within a country’s borders during a specific period. Index Tranche Credit Default Swap (CDS) A synthetic collateralized debt obligation (CDO) Gross Notional Exposure (GNE) based on a CDS index where each tranche (equity, The sum of the absolute values of long and short mezzanine, senior, and super senior) references notional amounts. The “notional” amount of a a different segment of the loss distribution of the derivative contract is the amount used to calculate underlying CDS index. payments due on that contract, just as the face amount of a bond is used to calculate coupon Intermediate Holding Company (IHC) payments. A company established or designated by an FBO under the Federal Reserve Board’s Regulation YY. Haircut Regulation YY requires that an FBO with U.S. non- The discount, represented as a percentage of par or branch assets of $50 billion or more must hold its market value, at which an asset can be pledged as entire ownership interest in its U.S. subsidiaries, collateral. For example, a $1,000,000 bond with a 5 with certain exclusions, through a U.S. IHC. percent haircut would collateralize a $950,000 loan. The purpose of a haircut is to provide a collateral Legal Entity Identifier(LEI) margin for a secured lender. A 20-character alpha-numeric code that connects to key reference information which enables clear and High-Quality Liquid Asset (HQLA) unique identification of legal entities participating An asset—such as a government bond—which is in global financial markets. The LEI system is considered eligible as a liquidity buffer in the U.S. designed to facilitate many financial stability banking agencies’ liquidity coverage ratio. High- objectives, including improved risk management quality liquid assets should be liquid in markets in firms; better assessment of microprudential during times of stress and, ideally, be central bank- and macroprudential risks; expedition of orderly eligible. resolution; containment of market abuse and financial fraud; and provision of higher-quality and Initial Margin more accurate financial data. Collateral that is collected to cover potential changes in the value of each participant’s position Leveraged Buyout (LBO) (that is, potential future exposure) over the An acquisition of a company financed by a private appropriate closeout period in the event the equity contribution combined with borrowed funds, participant defaults.
196 2020 FSOC // Annual Report with debt constituting a significant portion of the Margin purchase price. In the context of clearing activity, collateral that is collected to protect against current or potential Leveraged Loan future exposures resulting from market price While numerous definitions of leveraged lending changes or in the event of a counterparty default. exist throughout the financial services industry, generally a leveraged loan is understood to be a type Money Market Fund Liquidity Facility (MMLF) of loan that is extended to companies that already A facility established by the Federal Reserve under have considerable amounts of debt and/or have a section 13(3) of the Federal Reserve Act that non-investment grade credit rating or are unrated provides funding to U.S. depository institutions and and/or whose post-financing leverage significantly bank holding companies to finance their purchases exceeds industry norms or historical levels. of certain types of assets from MMFs under certain conditions. The MMLF is intended to assist MMFs in LIBOR meeting demands for redemptions by investors and A rate based on submissions from a panel of banks. to foster liquidity in the markets for the assets held LIBOR is intended to reflect the rate at which large, by MMFs. globally-active banks can borrow on an unsecured basis in wholesale markets. Money Market Mutual Fund (MMF) A type of mutual fund which invests in short-term, Limit (Up or Down) high-quality, liquid securities such as government The maximum price advance or decline from the bills, CDs, CP, or repos. previous day’s settlement price permitted during one trading session, as fixed by the rules of an exchange. Mortgage-Backed Security (MBS) Effective October 12, 2020, S&P 500 e-mini futures An ABS backed by a pool of mortgages. Investors are subject to a hard upside and downside limit of in the security receive payments derived from the 7 percent during non-U.S. trading hours. Prior to interest and principal payments on the underlying that, S&P 500 e-mini futures were subject to a hard mortgages. upside and downside limit of 5 percent during non- U.S. trading hours. Mortgage Servicing Company A company which acts as an agent for mortgage Liquidity Coverage Ratio (LCR) holders by collecting and distributing mortgage A standard to ensure that covered companies cash flows. Mortgage servicers also manage defaults, maintain adequate unencumbered, high-quality modifications, settlements, foreclosure proceedings, liquid assets to meet anticipated liquidity needs for a and various notifications to borrowers and investors. 30-day horizon under a standardized liquidity stress scenario. Mortgage Servicing Right (MSR) The right to service a mortgage loan or a portfolio Loan-to-Value Ratio of mortgage loans. The ratio of the amount of a loan to the value of the asset that the loan funds, typically expressed as Municipal Bond a percentage. This is a key metric when considering A bond issued by states, cities, counties, local the level of collateralization of a mortgage. governmental agencies, or certain nongovernment issuers to finance certain general or project-related Major Swap Participant activities. A person that is not a swap dealer and maintains a substantial position in swaps, creates substantial Net Asset Value (NAV) counterparty exposure, or is a financial entity that is An investment company’s total assets minus its total highly leveraged and not subject to federal banking liabilities. capital rules.
Glossary 197 Net Interest Margin (NIM) on a non-exchange platform (and, if so, the type of Net interest income as a percent of interest-earning platform). assets. Paris Club Net Stable Funding Ratio (NSFR) An informal group of official creditors whose role is A liquidity standard to promote the funding to find coordinated and sustainable solutions to the stability of internationally active banks, through the payment difficulties experienced by debtor countries maintenance of stable funding resources relative to assets and off-balance sheet exposures. Primary Dealer A financial institution that is a trading counterparty Open Market Operations of the Federal Reserve Bank of New York. Primary The purchase and sale of securities in the open dealers are expected to make markets for the market by a central bank to implement monetary Federal Reserve Bank of New York on behalf of its policy. official accountholders as needed, and to bid on a pro-rata basis in all Treasury auctions at reasonably Operational Resilience competitive prices. The ability of an entity’s personnel, systems, telecommunications networks, activities or processes Prudential Regulation to resist, absorb, and recover from or adapt to an Regulation aimed at ensuring the safe and sound incident that may cause harm, destruction, or loss of operation of financial institutions, set by both state ability to perform mission-related functions. and federal authorities.
Option Public Debt A financial contract granting the holder the All debt issued by Treasury and the Federal right but not the obligation to engage in a future Financing Bank, including both debt held by transaction on an underlying security or real asset. the public and debt held in intergovernmental The most basic examples are an equity call option, accounts, such as the Social Security Trust Funds. which provides the right but not the obligation to Not included is debt issued by government agencies buy a block of shares at a fixed price for a fixed other than Treasury. period, and an equity put option, which similarly grants the right to sell a block of shares. Qualifying Hedge Fund A hedge fund advised by a Large Hedge Fund Overnight Reverse Repurchase Agreement Facility Adviser that has a net asset value (individually or in (ON RRPF) combination with any feeder funds, parallel funds, A supplementary policy tool that the Federal Reserve and/or dependent parallel managed accounts) of uses to set the floor on rates to keep the federal at least $500 million as of the last day of any month funds rate in the target range set by the FOMC. in the fiscal quarter immediately preceding the adviser’s most recently completed fiscal quarter. Over-the-Counter (OTC) Large Hedge Fund Advisers are advisers that have at A method of trading which does not involve a least $1.5 billion in hedge fund AUM. registered exchange. An OTC trade could occur on purely a bilateral basis or could involve some degree Real Estate Investment Trust (REIT) of intermediation by a platform that is not required An operating company which manages income- to register as an exchange. An OTC trade could, producing real estate or real estate-related assets. depending on the market and other circumstances, Certain REITs also operate real estate properties in be centrally cleared or bilaterally cleared. The which they invest. To qualify as a REIT, a company degree of standardization or customization of must have three-fourths of its assets and gross documentation of an OTC trade will depend on income connected to real estate investment and the whether it is cleared and whether it is traded must distribute at least 90 percent of its taxable
198 2020 FSOC // Annual Report income to shareholders annually in the form of Securities Lending/Borrowing dividends. The temporary transfer of securities from one party to another for a specified fee and term, in exchange Repurchase Agreement (Repo) for collateral in the form of cash or securities. The sale of a security combined with an agreement to repurchase the security, or a similar security, on a Securitization specified future date at a prearranged price. A repo A financial transaction in which assets such as is a secured lending arrangement. mortgage loans are pooled, securities representing interests in the pool are issued, and proceeds from Residential Mortgage-Backed Security (RMBS) the underlying pooled assets are used to service and A security which is collateralized by a pool of repay the securities. residential mortgage loans and makes payments derived from the interest and principal payments on Security-Based Swap Dealer the underlying mortgage loans. A person that holds itself out as a dealer in security- based swaps, makes a market in security-based Risk-Weighted Assets (RWAs) swaps, regularly enters into security-based swaps A risk-based concept used as the denominator of with counterparties, or engages in any activity risk-based capital ratios (common equity tier 1, tier causing it to be known as a dealer or market maker 1, and total). The total RWAs for an institution are a in security-based swaps; does not include a person weighted total asset value calculated from assigned entering into security-based swaps for such person’s risk categories or modeled analysis. Broadly, total own account. RWAs are determined by calculating RWAs for market risk and operational risk, as applicable, and Short-Term Wholesale Funding adding the sum of RWAs for on-balance sheet, off- Short-term funding instruments not covered by balance sheet, counterparty, and other credit risks. deposit insurance which are typically issued to institutional investors. Examples include large Rollover Risk checkable and time deposits, brokered CDs, CP, The risk that as an institution’s debt nears maturity, Federal Home Loan Bank borrowings, and repos. the institution may not be able to refinance the existing debt or may have to refinance at less Special Purpose Acquisition Company (SPAC) favorable terms. Companies formed through an IPO to raise funds to purchase businesses or assets to be acquired after Run Risk the IPO. The risk that investors lose confidence in an institution—stemming from concerns about Supplementary Leverage Ratio (SLR) counterparties, collateral, solvency, or related Tier 1 capital of an advanced approaches banking issues—and respond by pulling back their funding. organization divided by total leverage exposure. All advanced approaches banking organizations must Secured Overnight Financing Rate (SOFR) maintain an SLR of at least 3 percent. The SLR is A broad measure of the cost of borrowing cash effective January 1, 2018, and organizations must overnight collateralized by Treasury securities. The calculate and publicly disclose their SLRs beginning rate is calculated as a volume-weighted median March 31, 2015. of transaction-level tri-party repo data as well as GCF Repo transaction data and data on bilateral Swap Treasury repo transactions. An exchange of cash flows with defined terms and over a fixed period, agreed upon by two parties. A swap contract may reference underlying financial products across various asset classes including interest rates, credit, equities, commodities, and FX.
Glossary 199 Swap Data Repository (SDR) Tier 2 Capital A person that collects and maintains information A regulatory capital measure which includes or records with respect to transactions or positions subordinated debt with a minimum maturity of in, or the terms and conditions of, swaps entered five years and satisfies the eligibility criteria in the into by third parties for the purpose of providing Revised Capital Rule. a centralized recordkeeping facility for swaps. In certain jurisdictions, SDRs are referred to as trade Time Deposits repositories. The Committee on Payments and Deposits that the depositor generally does not have Settlement Systems and IOSCO describe a trade the right to withdraw before a designated maturity repository as “an entity that maintains a centralized date without paying an early withdrawal penalty. A electronic record (database) of transaction data.” CD is a time deposit.
Swap Dealer Total Capital Section 1a(49) of the Commodity Exchange Act A regulatory capital measure comprised of tier 1 defines the term “swap dealer” (SD) to include any capital and tier 2 capital. See Tier 1 Capital and Tier person who: (1) holds itself out as a dealer in swaps; 2 Capital. (2) makes a market in swaps; (3) regularly enters into swaps with counterparties as an ordinary course Tri-Party Repo of business for its own account; or (4) engages in any A repo in which a clearing bank acts as third-party activity causing the person to be commonly known agent to provide collateral management services and in the trade as a dealer or market maker in swaps. to facilitate the exchange of cash against collateral between the two counterparties. Swap Execution Facility (SEF) A term defined in the Dodd-Frank Act as a trading Underwriting Standards system or platform which market participants use to Terms, conditions, and criteria used to determine execute and trade swaps by accepting bids and offers the extension of credit in the form of a loan or made by other participants, through any means of bond. interstate commerce. Variation Margin Swap Future Funds that are collected and paid out to reflect current exposures resulting from actual changes in A futures contract which mimics the economic market prices. substance of a swap. VIX (Chicago Board Options Exchange Market Swaption Volatility Index) An option granting the right to enter into a swap. A standard measure of market expectations of short- See Option and Swap. term volatility based on S&P equity index option prices. Syndicated Loan A loan to a commercial borrower in which financing Weighted Average Life (WAL) provided by a group of lenders. The loan package A weighted average of the maturities of all securities may have a revolving portion, a term portion, or held in a MMF’s portfolio. both Weighted-Average Maturity (WAM) Tier 1 Capital A weighted average of the time to maturity on all A regulatory capital measure comprised of common loans in an asset-backed security. equity tier 1 capital and additional tier 1 capital. See Common Equity Tier 1 Capital and Additional Tier 1 Capital.
200 2020 FSOC // Annual Report Window-Dressing Period-ending transactions that are reflected on a statement or report.
Yield Curve A graphical representation of the relationship between bond yields and their respective maturities.
Glossary 201
8 List of Charts
3.1.1 Household Debt as a Percent of Disposable Personal Income...... 11 3.1.2 Household Debt Service Ratio ...... 12 3.1.3 Owners’ Equity as Share of Household Real Estate ...... 12 3.1.4 Components of Consumer Credit...... 13 3.1.5 Change in Inquiries Relative to First Week of March 2020...... 13 3.1.6 Percentage of Mortgages in Forbearance ...... 14 3.1.7 Share Of Open Accounts that Transitioned to Delinquent ...... 14 3.2.1.1 Nonfinancial Corporate Credit as Percent of GDP...... 15 3.2.1.2 U.S. Nonfinancial Business Leverage...... 15 3.2.1.3 Bank Business Lending Standards...... 16 3.2.1.4 Investment Grade Corporate Bond Spreads ...... 16 3.2.1.5 Gross Issuance of Corporate Bonds...... 16 3.2.1.6 High-Yield Corporate Bond Spreads...... 17 3.2.1.7 Leveraged Loan Spreads ...... 17 3.2.1.8 Institutional Leveraged Loan Issuance...... 17 3.2.1.9 Nonfinancial Corporations Liquid Assets...... 18 3.2.1.10 Maturity Profile of U.S. Nonfinancial Corporate Debt...... 18 A.1 U.S. Corporate Defaults ...... 19 A.2 Chapter 11 Bankruptcy Filings...... 19 A.3 U.S. Nonfinancial Corporate Downgrade-Upgrade Ratio...... 20 A.4 Fallen Angel Debt...... 20 3.2.2.1 S&P 500 Volatility...... 22 3.2.2.2 S&P 500 Forward Price-to-Earnings Ratio...... 22 3.2.2.3 S&P 500 1-Year Price Returns by Sector...... 22 3.2.2.4 Performance of Global Stock Indices...... 23 3.3.1.1 Federal Debt Held by the Public...... 24 3.3.1.2 Publicly Held Treasury Securities Outstanding...... 24 3.3.1.3 Treasury General Account Balance...... 25 3.3.1.4 U.S. Treasury Yields...... 25 3.3.1.5 10-Year TIPS Yield and 10-Year Break Even...... 25 3.3.1.6 FRBNY Open Market Operations: Treasury Purchases...... 26 B.1 Intraday Volatility for 10-Year Treasury Yields...... 27 B.2 Bid-Ask Spread for 30-Year Treasury Bonds...... 27 B.3 Primary Dealer Inventories ...... 28 3.3.2.1 Changes in State and Local Government Tax Revenues...... 30 3.3.2.2 Municipal Bond Mutual Fund Flows...... 30
List of Charts 203 3.3.2.3 Municipal Bonds to U.S. Treasuries...... 30 3.3.2.4 Municipal Bond Issuance...... 31 C.1 Breakdown of State Tax Revenues ...... 34 C.2 Breakdown of Local Tax Revenues...... 34 C.3 Liabilities of Severely Underfunded Public Pension Plans...... 34 3.4.1.1 CP Outstanding by Issuer Type...... 35 3.4.1.2 CP Issuance by Issuer Type and Rating...... 35 3.4.1.3 CP Outstanding & MMF Holdings...... 36 3.4.1.4 Three Month CP Interest Rate Spreads ...... 36 3.4.1.5 Weekly CP Issuance by Tenor...... 36 3.4.1.6 Commercial Bank Deposit Growth...... 37 3.4.2.1 FICC Repo Balances and MMF Holdings...... 38 3.4.2.2 Primary Dealer Repo Agreements...... 38 3.4.2.3 Overnight Repo Volumes and Dealer Inventories...... 38 3.4.2.4 Primary Dealer Reverse Repo Agreements...... 39 3.4.2.5 Primary Dealer Repo Collateral...... 39 3.4.2.6 Collateral in the Tri-Party Repo Market...... 39 3.4.2.7 Repo Rate Spreads...... 40 3.4.2.8 Value of Securities on Loan...... 41 3.4.2.9 U.S. Securities Lending Cash Reinvestment...... 42 3.4.2.10 U.S. Securities Lending Cash Reinvestment Collateral...... 42 3.4.3.1 U.S. Futures Markets: Volume...... 46 3.4.3.2 3-Month Implied Volatility ...... 46 3.4.3.3 U.S. Futures Markets Open Interest...... 46 3.4.3.4 Micro Futures: Open Interest...... 47 3.4.3.5 U.S. Treasury Futures: Open Interest...... 47 3.4.3.6 Exchange-Traded Equity Option Volume...... 48 3.4.3.7 Call Option Volume for Select Technology Stocks...... 48 3.4.3.8 Options on Futures: Open Interest...... 48 3.4.3.9 Options on Futures: Volume...... 49 3.4.3.10 Options on Futures: Delta Adjusted Open Interest...... 49 3.4.3.11 Delta Adjusted Options on Futures by Asset Classes...... 49 3.4.3.12 Options on 10-Year Treasury Futures...... 50 3.4.3.13 OTC Options: BHC Gross Notional Outstanding...... 50 3.4.3.14 OTC Options: BHC Net Notional Outstanding...... 50 3.4.3.15 Derivatives Notional Volume...... 51 3.4.3.16 Derivatives Notional Amount Outstanding...... 51 3.4.3.17 Size of Interest Rate Swap Market...... 51 3.4.3.18 Global OTC Positions ...... 52 3.4.3.19 Commodity Index Swaps: Annual Open Interest...... 52
204 2020 FSOC // Annual Report 3.4.3.20 Commodity Index Swaps: Monthly Open Interest...... 52 3.4.3.21 Commodity Swaps: Open Interest...... 53 3.4.3.22 Commodity Swaps by Asset Class...... 53 3.4.3.23 Margin Funds Held at CFTC Registered FCMs ...... 53 3.4.3.24 FCM Concentration: Customer Futures Balances...... 54 3.4.3.25 FCM Concentration: Customer Swap Balances...... 54 3.4.3.26 Concentration of Swap Positions for Registered SDs...... 54 3.4.3.27 Interest Rate Swap SEF Trading Volumes...... 55 3.4.3.28 Credit Default Swap SEF Trading Volumes...... 55 3.4.4.1 Commodities Futures & Options: Open Interest ...... 56 3.4.4.2 Total Net Asset Value – Commodity ETFs...... 56 3.4.4.3 Metals Indices...... 56 3.4.4.4 Cash-Futures Spread: Gold...... 57 3.4.4.5 Agriculture Prices...... 57 3.4.4.6 Cash-Futures Spread: Cattle...... 58 3.4.4.7 Net Farm Income ...... 58 3.4.4.8 Energy Futures & Options: Open Interest...... 59 3.4.4.9 Energy Futures & Options by Product...... 59 3.4.4.10 Global Petroleum Consumption and Production...... 60 3.4.4.11 WTI Crude Oil Futures...... 60 3.4.4.12 Natural Gas Inventories...... 60 3.4.4.13 Natural Gas Forward Curves...... 61 3.4.5.1 House Prices by Census Division...... 61 3.4.5.2 Home Sales...... 62 3.4.5.3 New Housing Starts and Price Changes...... 62 3.4.5.4 Homeownership and Vacancy Rates...... 63 3.4.5.5 Mortgage Originations and Rates...... 63 3.4.5.6 Purchase Origination Volume by Credit Score...... 64 3.4.5.7 Shares of Mortgages by Equity Percentage...... 64 3.4.5.8 Mortgage Delinquency...... 65 3.4.5.9 Forbearance Rates by Investor Type...... 66 3.4.5.10 Mortgage Originations by Product...... 67 3.4.5.11 RMBS Issuance...... 67 3.4.5.12 Cumulative MBS Purchases by the Federal Reserve...... 68 3.4.6.1 Conduit CMBS Delinquency and Foreclosure Rate...... 70 3.4.6.2 Conduit CMBS Delinquency Rates by Industry...... 70 3.4.6.3 CMBS Issuance...... 71 3.4.6.4 Commercial Property Price Growth...... 72 3.4.6.5 Capitalization Rates and Spreads...... 72 E.1 Sector Equity REIT Indices...... 74
List of Charts 205 3.5.1.1 Categorization of Large U.S. BHCs...... 77 3.5.1.2 Total Assets by BHC Type...... 78 3.5.1.3 Common Equity Tier 1 Ratios...... 78 3.5.1.4 Common Equity Tier 1 Ratios at U.S. G-SIBs...... 79 3.5.1.5 Payout Rates at U.S. G-SIBs...... 80 3.5.1.6 Supplementary Leverage Ratios at U.S. G-SIBs...... 80 3.5.1.7 Return on Assets...... 81 3.5.1.8 Net Interest Margins...... 81 3.5.1.9 Selected Sources of Funding at U.S. G-SIBs...... 81 3.5.1.10 Deposit Growth, All Commercial Banks...... 82 3.5.1.11 Effective Deposit Rates by BHC Category...... 82 3.5.1.12 Delinquency Rates on Real Estate Loans...... 82 3.5.1.13 Delinquency Rates on Selected Loans...... 83 3.5.1.14 Provisions to Loans Ratios at BHCs...... 83 3.5.1.15 C&I Loan Growth, All Commercial Banks...... 84 3.5.1.16 Loans to Nondepository Financial Institutions...... 84 3.5.1.17 High-Quality Liquid Assets by BHC Type...... 84 3.5.1.18 Selected Liquid Assets at All BHCs...... 85 3.5.1.19 Liquidity Coverage Ratios at U.S. G-SIBs...... 85 3.5.1.20 Held-to-Maturity Securities ...... 85 3.5.1.21 Duration Gap...... 86 3.5.1.22 Bank Stock Performance...... 86 3.5.1.23 Price-to-Book of Select U.S. G-SIBs...... 86 3.5.1.24 5-Year CDS Premiums of Select U.S. G-SIBs...... 87 3.5.1.25 5-Year CDS Premiums of Select Foreign Banks ...... 87 3.5.1.26 Initial and Stressed Capital Ratios...... 88 3.5.1.27 .Minimum CET1 Capital Ratios in the Severely Adverse and Alternative Downside Scenarios...... 89 3.5.1.28 FDIC-Insured Failed Institutions ...... 89 3.5.1.29 Commercial Bank and Thrift Net Income...... 90 3.5.1.30 Total Assets of Largest Insured Depository Institutions ...... 91 3.5.1.31 U.S. Branches and Agencies of Foreign Banks: Assets...... 91 3.5.1.32 U.S. Branches and Agencies of Foreign Banks: Liabilities...... 92 3.5.1.33 Credit Union Income...... 93 3.5.1.34 Credit Union Deposits...... 95 3.5.1.35 Credit Union Net Long-Term Assets...... 95 3.5.1.36 Credit Union Composition of Assets...... 95 3.5.2.1 Number of Broker-Dealers and Industry Net Income...... 96 3.5.2.2 Broker-Dealer Revenues...... 96 3.5.2.3 Broker-Dealer Assets and Leverage...... 97
206 2020 FSOC // Annual Report 3.5.2.4 REITs Total Assets...... 98 3.5.2.5 mREIT Stock Performance ...... 98 3.5.2.6 Agency MBS Spread to Treasuries ...... 99 3.5.2.7 MMF Assets by Fund Type...... 100 3.5.2.8 Liquid Asset Shares of Prime MMFs...... 101 3.5.2.9 Weighted Average Maturities by Fund Type...... 101 3.5.2.10 Net Assets of the Investment Company Industry...... 103 3.5.2.11 Monthly Bond Mutual Fund Flows...... 103 3.5.2.12 Monthly Equity Mutual Fund Flows...... 103 3.5.2.13 Monthly Bank Loan Mutual Fund Flows...... 104 3.5.2.14 Monthly High-Yield Mutual Fund Flows...... 104 3.5.2.15 Cumulative Equity Fund Flows...... 104 3.5.2.16 Cumulative Equity and Fixed Income Fund Flows...... 105 3.5.2.17 U.S.-Listed ETF AUM...... 105 3.5.2.18 ETF Assets by Category of Investment...... 105 3.5.2.19 Monthly ETF Flows: Fixed Income Funds...... 106 3.5.2.20 Monthly ETF Flows: Equity Funds...... 106 3.5.2.21 Monthly Inverse and Leveraged ETF Flows...... 106 3.5.2.22 Hedge Fund Gross and Net Assets...... 107 3.5.2.23 Hedge Fund Secured Financing ...... 108 3.5.2.24 Hedge Fund Borrowing: Composition of Creditors ...... 108 3.5.2.25 Hedge Fund Financing Liquidity...... 108 3.5.2.26 Hedge Fund Gross Exposures by Asset Class...... 109 3.5.2.27 Hedge Fund Treasury Exposures...... 110 3.5.2.28 M&A Loan Volume for Private Equity-Backed Issuers...... 111 3.5.2.29 Public Plan Allocation to Alternative Assets...... 113 3.5.2.30 Insurance Industry Net Income...... 115 3.5.2.31 Insurance Industry Capital and Surplus...... 115 3.5.2.32 Consumer Loans and Leases Outstanding...... 117 3.5.2.33 Business Loans and Leases Outstanding...... 117 3.5.2.34 ABS Issuance...... 118 3.6.1.1 Initial Margin Requirements: DTCC...... 119 3.6.1.2 Maximum Uncovered Exposure for DTCC...... 119 3.6.1.3 Liquidity Demand at Derivatives Clearing Organizations ...... 121 3.6.1.4 Initial Margin: U.S. Exchange Traded Derivatives...... 121 3.6.1.5 Initial Margin: OTC Derivatives...... 121 3.6.1.6 Global OTC Central Clearing Market Share...... 122 3.6.1.7 Average Clearing Rates for OTC Trading...... 122 3.6.3.1 Market Capitalization of Blockchain-Based Digital Assets...... 126 3.7.1.1 Federal Reserve Swap Lines...... 129
List of Charts 207 3.7.1.2 Change in USD Exchange Rates, Advanced Economies...... 129 3.7.1.3 Change in USD Exchange Rates, Emerging Markets...... 129 3.7.1.4 Real U.S. Dollar Trade-Weighted Index...... 130 3.7.2.1 Advanced Economies Real GDP Growth...... 130 3.7.2.2 General Government Gross Debt to GDP...... 130 3.7.2.3 Outstanding Negative Yielding Debt...... 131 3.7.2.4 Euro Area H1 2020 Real GDP...... 131 3.7.2.5 Euro Area Business and Consumer Surveys...... 131 3.7.2.6 Euro Area 10-Year Sovereign Yields...... 133 3.7.2.7 Euro Area 10-Year Spreads...... 133 3.7.2.8 UK COVID-19 Business Loan Schemes...... 134 3.7.2.9 Japanese Consumer Price Inflation...... 134 3.7.2.10 Japan 10-Year Government Bond Yield...... 135 3.7.3.1 2020 Real GDP Revisions for Developing Economies...... 136 3.7.3.2 COVID-19 Impact on 2020 Current Account Balances...... 136 3.7.3.3 Emerging Market Sovereign Bond Spreads...... 136 3.7.3.4 Foreign Investor Capital Inflows to EMEs...... 137 3.7.3.5 Foreign Investor Portfolio Inflows to EMEs...... 137 3.7.3.6 Chinese Overseas Lending...... 138 3.7.3.7 Chinese Real GDP Growth and its Components ...... 139 3.7.3.8 Credit to the Chinese Nonfinancial Private Sector...... 139 3.7.3.9 Chinese Credit Growth...... 139 4.1.1 Total Assets of the Federal Reserve...... 143 4.1.2 Net Portfolio Holdings of 13(3) Facilities ...... 143
208 2020 FSOC // Annual Report
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